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P2 Performance Management
Step 1 Learning Phase Study Programme
Page
Introduction to the paper and the course................................................................................................................. 4
Summary Skills Bank and Analysis of Verbs........................................................................................................... 9
1
2
3
4
Checkpoint 1
5
6
7
8
125
197
Checkpoint 4
14
15
16
17
Checkpoint 3
11a
11b
12
13
55
Checkpoint 2
8
9a
9b
10
275
INTRODUCTION
The syllabus
The broad syllabus headings and their relative weightings are:
Topic
Study weighting
30%
30%
20%
20%
Aims
The syllabus aims to test the students ability to:
Discuss concepts of cost and revenue relevant to pricing and product decisions.
Evaluate techniques for analysing and managing costs for competitive advantage.
Evaluate performance using budgets, recognising alternative approaches and sensitivity to variable
factors.
Discuss the broader managerial issues arising from the use of budgets in control.
Discuss the use of responsibility centres in devising organisation structure and in management control.
Discuss the broader managerial issues arising from the division of the organisation into responsibility
centres.
INTRODUCTION
1(a) Discuss the principles of decision-making including the identification of relevant cash
flows and their use alongside non-quantifiable factors in making rounded judgements.
Chapter 1
1(b) Discuss the possible conflicts between cost accounting for profit reporting and inventory
valuation and the convenient availability of information for decision-making.
Chapter 1
1(c) Discuss the particular issues that arising in pricing decisions and the conflict between
marginal cost principles and the need for full recovery of all costs incurred.
Chapter 6
2(a) Explain the usefulness of dividing costs into variable and fixed components in the context
of short-term decision-making.
Chapter 1
2(b) Interpret variable/fixed cost analysis in multiple product contexts to break-even analysis
and product mix decision-making, including circumstances where there are multiple
constraints and linear programming methods are needed to identify optimal solutions.
Chapters 2, 3, 4
&5
2(c) Discuss the meaning of 'optimal' solutions and how linear programming methods can be
employed for profit maximising, revenue maximising and satisfying objectives.
Chapters 3 & 4
2(d) Analyse the impact of uncertainty and risk on decision models based on CVP analysis
Chapter 5
Chapter 6
3(c) Explain why joint costs must be allocated to final products for financial reporting
purposes, but why this is unhelpful when decisions concerning process and product
viability have to be taken.
Chapter 1
Chapter 6
1(a) Compare and contrast value analysis and functional cost analysis.
Chapter 7
1(b) Evaluate the impacts of just-in-time production, the theory of constraints and total quality
management on efficiency, inventory and cost.
Chapter 9a
1(c) Explain the concepts of continuous improvement and Kaizen costing that are central to
total quality management.
Chapter 9a
Chapter 9a
1(e) Apply learning and experience curves to estimate time and cost for new products and
services
Chapter 7
Chapter 8
1(g) Explain how process re-engineering can be used to eliminate non-value adding activities and
reduce activity costs
Chapter 9a
1(h) Explain how target costs can be derived from target prices and the relationship between
target costs and standard costs
Chapter 7
1(i) Discuss the concept of life cycle costing and how life cycle costs interact with marketing
strategies at each stage of the life cycle
Chapter 7
1(j) Discuss the concept of the value chain and discuss the management of contribution/profit
generated throughout the chain
Chapter 9b
INTRODUCTION
1(k) Discuss gain sharing arrangements whereby contractors and customers benefit if contract
targets for cost, delivery etc are beaten
Chapter 9b
1(l) Analyse direct customer profitability and extend this analysis to distribution channel
profitability through the application of activity-based profitability calculations.
Chapters 8
1(m) Apply Pareto analysis as a convenient technique for identifying key elements of data and
in presenting the results of other analyses, such as activity-based profitability calculations
Chapter 8
1(a) Explain the concepts of feedback and feedforward control and their application in the use
of budgets for planning and control.
Chapter 10
1(b) Explain the concept of responsibility accounting and its importance in the construction of
functional budgets that support the overall master budget.
Chapter 10
1(c) Identify controllable and uncontrollable costs in the context of responsibility accounting
and why uncontrollable costs may or may nor be allocated to responsibility centres.
Chapter 10
Chapter 11b
2(b) Evaluate the consequences of what if scenarios and their impact on the master budget
Chapter 10
3(a) Discuss the impact of budgetary control systems and setting of standard costs on human
behaviour.
Chapter 10
Chapter 11b
3(c) Compare and contrast traditional approaches to budgeting with recommendations based
on the 'balanced scorecard'.
Chapter 11b
3(d) Discuss the criticisms of budgeting, particularly from the advocates of beyond budgeting
techniques.
Chapter 10
1(a) Discuss use of cost, revenue, profit and investment centres in devising organisation
structure and in management control.
Chapter 12
2(a) Discuss cost information in appropriate formats for cost centre managers, taking due
account of controllable/uncontrollable costs and the importance of budget flexing.
Chapters 10 & 12
2(b) Discuss revenue and cost information in appropriate formats for profit and investment
centres managers, taking due account of cost variability, attributable costs, controllable
costs and identification of appropriate measures of profit centre contribution.
Chapter 12
Chapter 12
3(a) Discuss the likely behavioural consequences of the use of performance metrics in
managing cost, profit and investment centres.
Chapter 12
3(b) Discuss the typical consequences of a divisional structure for performance measurement
as divisions compete or trade with one another.
Chapters 12 & 13
3(c) Discuss the likely consequences of different approaches to transfer pricing for divisional
decision-making, divisional and group profitability, the motivation of divisional
management and the autonomy of individual divisions.
Chapter 13
3(d) Discuss in principle the potential tax and currency management consequences of internal
transfer pricing policy.
Chapter 13
INTRODUCTION
35% Discussion
40% Knowledge
60% Application
Marks
Section A
50
Section B
50
100
Section B
INTRODUCTION
Key to icons
Question practice from the Question and Answer Bank
This is a question we recommend you attempt to reinforce your learning on a key topic.
Real-life examples
For further details see your Checkpoint Guidance
Formula to learn
5 Professional
presentation of
numbers and narrative
answers
4 Analysis of
requirements to ensure
your answer specifically
addresses the
requirements
1 Effective use
of the 20 minutes
reading time at the
start of the exam
3 Exam Approach
to ensure that you
play to your strengths
and thereby
maximise your marks
2 Disciplined time
management to
ensure that all parts
of the question are
answered in the time
allowed
2.
3.
10
11
12
13
Overview
Relevant costs
Relevant costs
Non-relevant costs
Other factors
Non-financial /
qualitative factors
Information for
reporting and decisionmaking
Relevant costing in
relation to accounting
concepts
14
Overview
Short-term decisions
Make or buy
Minimum price
Further processing
Shutdown
Accept or reject
15
Cash
Future
Incremental / Specific
Opportunity cost
Definition
1.1
1.2
Future
Cash flow
Incremental
Opportunity costs the value of a benefit sacrificed when one course of action is
chosen in preference to an alternative. The opportunity cost is represented by the
potential benefit forgone from the best rejected course of action.
Opportunity costs are relevant for decision-making and are likely to arise when there
are a number of possible uses of a scarce resource.
(b)
16
Non-relevant costs
Sunk costs
Committed costs
Notional costs
Fixed costs
Sunk costs costs already incurred. Not relevant in decision-making and are therefore
ignored.
Committed costs these have already been committed to and so are not relevant to the
decision. Examples might include the cost of materials under a long-term contract.
Notional costs non-cash items, or accountancy entries.
Fixed costs allocated and general fixed costs are not specific to a decision. Avoidable
fixed costs would be relevant.
17
In inventory
If take from
If take from
inventory will be inventory wont
replaced
be replaced
Lecture example 1
If take from
inventory cant
replace it
X plc intends to print a catalogue for a one-off special promotion. The catalogue requires 120
boxes of a particular type of paper that is not regularly used by X plc although a limited amount
remains in X plc's inventory from a similar job.
The cost when X plc bought the paper two years ago was $17 per box and there are 50 boxes in
inventory. The boxes could be sold for $14 each or could be purchased in the market for $22 each.
Required
Calculate the relevant cost of the paper to be used in printing the catalogue.
Solution
18
(a)
(b)
(c)
19
Lecture example 2
Technique Demonstration
(10 kg @ $2)
(5 hrs @ $6)
Selling price
Contribution
Required
What is the cost of using 15 hours of labour for the contract?
Solution
20
$/unit
20
30
50
75
25
2.1
The minimum price for a one-off decision is its total relevant costs. This is the price at which
the business would breakeven.
Lecture example 3
LB Ltd has been approached by a customer to manufacture a specialised machine. This would be
a one-off order which LB Ltd would undertake in addition to its normal budgeted production.
The assistant accountant has prepared the following quotation:
Note
Direct materials:
Aluminium plating (20m2 @ $10per m2)
Rivets (100 @ $1 each)
Direct labour:
Skilled (50 hrs @ $16 per hour)
Semi-skilled (20 hrs @ $10 per hour)
Overheads
1
2
200
100
3
4
5
800
200
100
1,400
140
1,540
308
$1,848
Notes
1
The aluminium plating is regularly used on other work within the business. It has an
inventory value of $10 per m2 although the current purchase price has recently risen to
$12 per m2.
Rivets are currently held in inventory and cost $1 each although the company has no further
use for them. They could be sold to a scrap merchant for $0.50 each.
Skilled labourers are paid $16 per hour and are currently fully utilised on other work. If the
job was undertaken it would be necessary to either work a maximum of 40 hours of overtime
(paid at time and a half) and/or reduce the production of another product which earns
contribution of $20 per hour.
It is policy to add 10% to the production cost of each job to cover the administration cost of
orders accepted.
Profit of 20% of total cost is added to each job as part of standard pricing policy.
Required
Prepare, on a relevant cost basis, the minimum price which should be quoted for the job and
suggest other factors that should also be considered prior to reaching a final decision.
21
Solution
Note
Aluminium plating
Rivets
Skilled labour
Semi-skilled labour
Overheads
Administration overhead
Total relevant cost
Profit
Minimum price
Notes
Q2 Exe
Accept or reject
3.1
Accept or reject decisions use exactly the same principles as minimum price decisions. A
project with a positive return on a relevant cost basis should be accepted, a negative return
should be rejected.
22
Make or buy
4.1
Organisations may need to decide to make components, or provide services, themselves inhouse, or alternatively, to buy them from an outside supplier.
4.2
In-house production will provide greater control over the work performed but will also use
capacity which will give rise to opportunity costs.
Lecture example 4
Preparation question
C
54.00
Material cost
Component B (external purchase price)
Direct labour
Variable overhead
8.00
4.00
2.00
14.00
9.50
14.50
8.00
4.00
36.00
15,000
20,000
23,400
40,000
Determine the maximum price that should be paid to an external supplier for component B.
(b)
Assuming B is bought from the external supplier, how many units of C must be sold to
breakeven on a relevant cost basis?
Solution
23
Shutdown decisions
5.1
These decisions may involve the closure of divisions or products of a business that appear
to be loss-making.
5.2
Shutdown decisions should not be made on the basis of profitability under absorption
costing as this fails to consider the relevance of fixed overheads.
5.3
Shutdown decisions should focus on relevant costs (and revenues) if the closure is made.
Lecture example 5
Preparation question
Lewis Ltd manufactures three products, the Keir, the Lucy and the Gareth. Forecasted income
statements for next year are as follows:
Sales
Cost of production
Materials
Labour
Variable overhead
Fixed overhead
Gross margin
Selling costs
Net margin
K
$'000
600
L
$'000
300
G
$'000
200
Total
$'000
1,100
200
95
75
200
30
40
(10)
60
20
10
50
160
20
140
30
10
5
80
75
15
60
265
75
190
The directors are considering the closure of the Keir product line, due to the losses incurred. You
obtain the following information.
(1)
Solution
24
Processes
6.1
In certain circumstances more than one product may be produced from a single process.
These products may sell in their current state or may need further, separate processing
before they can be sold.
Joint costs
6.2
The costs of the process will need to be apportioned between the products created by the
process in order to
(a) Value stock
(b) Prepare financial accounts
25
These costs are not relevant when deciding whether to process any product further
because they are
(a) Sunk
(b) Arbitrarily apportioned
6.4
The total joint cost may be relevant for decisions regarding the viability of the process as
a whole.
6.5
Physical quantity
Relative sales value
Net realisable value
Losses
6.6
Frequently processes cause losses of volume during processing. When these losses are
expected they are referred to as normal. Losses above normal level are abnormal losses.
6.7
6.8
Abnormal losses/gains are valued at production cost. Abnormal losses may later be sold as
scrap when the net loss/gain is calculated.
Calculation
6.9
The apportionment of joint costs is performed using the calculation of a cost per unit
Cost per unit of output =
26
Lecture example 6
A process produces two joint products. The following process account relates to last month's
production.
Process
Materials
Labour
Variable overhead
Units
5,000
$
25,250
14,950
7,500
5,000
47,700
Normal loss
Product A
Product B
Units
500
2,500
2,000
0
26,500
21,200
5,000
47,700
Each of the products can be sold immediately after the process or further processed individually
before being sold.
Product
Selling price
after process
$/Unit
10
12
A
B
Selling price
after further
processing
$ /Unit
13
15
Further variable
processing cost
(a)
Determine the optimal processing plan for each of the two products, A and B.
(b)
Solution
27
$/Unit
3.75
2.75
Q1 Z Ltd
28
Non-financial/qualitative factors
7.1
Chapter 1a
section 8
Non quantifiable
factors in
decision making
Exam questions may require a discussion of other factors, aside from the financial
calculation, that should be taken into account in making any decision.
7.3
Factors include:
(a)
(b)
(c)
(d)
(e)
Employees
Customers
Competitors
Suppliers
Flexibility
7.4
Timescale can also be relevant. Many fixed costs can be varied, but only in the long-term.
8.1
Information required for decision-making differs considerably from that used for profit
reporting and inventory valuation.
8.2
In accordance with IAS 2, absorption costing must be used for inventory valuation purposes
and therefore for profit reporting. However, the inclusion of an amount for fixed overheads
means it cannot be used for decision making:
8.3
(a)
The allocation of overhead is an arbitrary apportionment and so may not reflect the
actual cost of making / not making a product
(b)
Fixed overheads do not change in the short term and therefore should not be
considered when decision making
Absorption costing does however recognise that selling prices must cover all costs if a
business is to continue to be profitable.
29
Chapter 1a
section 7
Relation to
accounting
concepts
9.1
Accounts are prepared in accordance with two fundamental concepts: accruals and going
concern. These concepts are not necessarily consistent with information for decision
making.
Accruals
9.2
This concept looks to report transactions in the period to which they relate. However,
relevant costing is concerned only with future transactions and with cashflows. Sunk costs
are ignored in decision making even if they are incurred in the assessment of the particular
project that is being considered.
Going concern
9.3
Financial statements are prepared on the assumption that an entity will continue in the
foreseeable future. Relevant costing could be said to comply with this concept as the
undertaking of decisions about future projects will only be considered if the business is still
trading.
9.4
However, caution needs to be exercised as if all projects are undertaken on a relevant cost
basis and are priced using a minimum price then the projects will not be making enough
money to cover the fixed costs of the business.
Financial reporting
Relevant costing
Relevance
Materiality
Reliability
Faithful representation
Substance over form
Neutrality
Prudence
Completeness
30
10 Chapter summary
Section
Topic
Summary
Relevant costs
sunk
committed
notional
historic
Minimum price
Accept or Reject
Make or Buy
Shutdown
Further processing
Non-financial /
qualitative factors
Information for
reporting vs
decision-making
31
END OF CHAPTER
32
33
Overview
Marginal costing
Shadow price
Throughput accounting
34
1.1
The production and sales plans of a business may be limited by a limiting factor / scarce
resource (the 'principal budget factor').
This could be:
(a)
(b)
(c)
(d)
(e)
Market demand
Materials
Manpower (labour)
Machine hours
Money
Single constraint
2.1
If a business makes more than one product, it will want to find the product mix which will
maximise profit given the limiting factor. This is done by maximising contribution as follows.
(a)
(b)
(c)
35
Lecture example 1
Gorgo Ltd is preparing its production plan for the next week and has estimated maximum demand
from its customers as follows.
A
B
C
Units
50
50
50
Sales price
Variable cost:
Materials ($5/kg)
Labour
Fixed cost
Profit
A
$
150
B
$
120
C
$
100
50
50
50
0
30
50
20
20
15
40
10
35
These demand figures do not include a long-term contract for the delivery of five units of each
product to an important customer. If this contract is not satisfied, then Gorgo will have to pay a
substantial penalty.
The production director is concerned as the materials and labour used in production may be in
short supply. Gorgo does not hold any inventory of raw materials but would be able to recruit
temporary workers, who are equally as able as the permanent staff, as required, for a 10%
premium over the usual rate.
The availability of materials is expected to be restricted to 845 kg.
Required
Prepare calculations to determine the production mix that will maximise Gorgo's profit next week.
Solution
36
Throughput accounting
2.2
37
Shadow price
A shadow price is:
(a)
The additional contribution generated from one additional unit of limiting factor.
(b)
The opportunity cost of not having the use of one extra unit of limiting factor.
(c)
The maximum extra amount that should be paid for one additional unit of scarce
resource.
Lecture example 2
Technique demonstration
Required
Using the information from Gorgo in Lecture example 1, determine the shadow price of material.
Solution
4
Q3 KL Retail
Outlet
Chapter summary
Section
Topic
Summary
Principal budget
factor
Single constraint
Shadow price
Linear programming:
The graphical method
39
Overview
Linear Programming:
The graphical method
Multiple constraints
(two products)
Graphical linear
programming
Shadow prices
40
Slack / Surplus
Multiple constraints
The methods discussed in Chapter 2 cannot be used when:
(a)
(b)
Under these conditions linear programming is used and can be solved using:
(a)
(b)
Graphs, or
Computer programs (Chapter 4)
2.1
Graphical linear programming can be used when two products/services (variables) exist.
Steps
2.2
Follow these steps when you are trying to solve a problem using the graphical method.
Formulating the model
(a)
Define variables
(b)
(c)
The management
guide to fast food
(d)
(e)
Identify the feasible space, ie those combinations of variables which are possible
within the resource constraints
(f)
Plot the slope of the objective function and slide to optimal point (away from the origin
for a maximum, towards the origin for a minimum)
(g)
41
Lecture example 1
Technique demonstration
KG Ltd makes two products, the Purse and the Handbag. Each purse earns $5 contribution and
each handbag earns $6. Inputs are as follows:
Purse
Handbag
2
Leather
1 m
2m2
Skilled labour
45 min
30 min
There are six skilled labourers each working a 35-hour week and delivery contracts limit the
amount of leather available to 600m2 each week.
KG Ltd has an EU quota ruling whereby it has to produce at least as many handbags as it does
purses.
Leather costs $8 per m2, wages are paid at $4.20 per hour.
Required
Determine the optimal production plan for KG Ltd and calculation the contribution that can be
achieved.
Solution
(a)
Define variables
(b)
(c)
42
Plot a graph
43
(f)
(g)
44
Slack / Surplus
2.3
Slack occurs when the maximum availability of a resource is not used i.e. there is spare
material.
Surplus represents the production above the minimum requirement.
Lecture example 2
Technique demonstration
Solution
Shadow prices
2.4
Section 3.1.3
Ranges for
limiting factors
Shadow prices can be calculated from the graphical method, by relaxing or constraining one
of the limiting factors at a time by a small amount (usually one unit), and recalculating the
optimal solution and associated contribution.
45
Lecture example 3
Technique demonstration
Determine the maximum KG Ltd would be prepared to pay to obtain one further hour of labour.
Solution
Assumptions
3.1
46
4
Q4 Linear
programming
Chapter summary
Section
Topic
Summary
Multiple constraints
Graphical linear
programming
47
END OF CHAPTER
48
Linear programming:
The simplex method
Interpretation of a linear
programming solution has been
required.
49
Overview
Linear Programming:
The simplex method
3 or more variables
Output
Inputs
Slack variables
50
1.1
The computer-based method must be used when there are three or more variables.
Computers use the simplex method, which is an iterative process to calculate:
(a)
(b)
(c)
(d)
(e)
1.2
The syllabus does not require you to use simplex but to:
(a)
(b)
Inputs
2.1
The inputs into the linear programming package will be very similar to those seen in Chapter
3, but they also include slack variables.
Based on the information in Chapter 3, Lecture example 1, the inputs would be as follows:
Let P
Let H
Let S1
Let S2
Let S3
Section 4 Using
linear
programming
=
=
=
=
=
Maximise Z = 5P + 6H
Subject to:
(Leather)
(Labour)
(Quota)
(Non-negativity)
2.2
1.5P + 2H + S1 = 600
0.75P + 0.5H + S2 = 210
P H + S3 = 0
P, H 0
51
Lecture example 1
Preparation question
Required
Produce the initial tableau for the production problem above.
Solution
Variable
S1
S2
S3
Soln
Output
3.1
The computer output will vary according to the linear programming package used. However,
all packages will incorporate similar information.
Lecture example 2
The output from two computers used to solve the problem highlighted in Lecture example 1 is as
follows:
Objective function value:
1,880.000
Variable
P
H
Constraint
S1
S2
S3
Variable
S1
Value
160.000
180.000
Relative loss
0
0
Slack/Surplus
0.000
0.000
20.000
Shadow price/worth
2.667
1.333
0.000
S2
1
0
Soln
160.000
180.000
S3
Z
S3
2.667
52
1.333
20.000
1880.000
Explain the meaning of each of the values of the two linear programming packages.
(b)
Should KG Ltd accept an offer from Edwards Ltd to supply them with extra leather for
$10.50/m2?
Solution
53
4
Q5 Simplex
Chapter summary
Section
Topic
Summary
Computer based
linear programming
Inputs
Output
optimal production
contribution generated
END OF CHAPTER
54
CHECKPOINT 1
Take some time to reflect on the knowledge and skills you covered during Stage 1. If you feel you need further
clarification on any of the key areas listed below you can use the on-line lecture for the relevant chapter. The
Course Notes section for each chapter (starting overleaf) provides helpful guidance (and time commitments) on
how to focus your review on the key learning points in your notes.
Key knowledge
Brought forward knowledge
Some items in stage 1 you may have seen before in your studies such as single limiting factors. The P2 syllabus
takes these topics further branching into multi limiting factors, slack, surplus and shadow prices.
Relevant Costing
Relevant costing is probably the most important technique from stage 1 to get to grips with quickly. Many of the
decisions within the P2 syllabus centre around this concept. Exam questions may focus specifically on
identifying the relevant cost in a given scenario but others will require application of this technique.
Linear Programming
Linear programming involves preparing graphs. Many students often discover that whilst they felt confident with
these techniques in class, the reality of attempting these on their own is more difficult than they had envisaged so
it is important to practise these techniques now.
Try to memorise the steps involved in a linear programming problem and remember that the simultaneous
equations prepared to discover the optimal point are for the two lines on the graph that intersect at the optimal
point. (This will not necessarily be for labour and materials!)
Key skills
You should realise that you have already begun to learn some of the key skills required to do well in the P2
exam. Clear presentation is essential so that the examiner can follow and understand your answer.
55
CHECKPOINT 1
65 mins
Key areas - use the online lectures to selectively review these if you need to
The definitions of relevant cost and opportunity cost
The relevant cost of materials and labour
Course Notes
This is a key chapter that underpins many sections of the course. Review the relevant cost
charts in sections 1.4 and 1.5 and make sure you understand them.
5 mins
Run through the examples once more to ensure you have got to grips of the fundamentals of
relevant costing
15 mins
Ensure you can list the non financial factors that would be considered as part of the decision
making process
5 mins
Question Practice
Attempt Q1 from the Q&A Bank at the back of your course notes. This is a good example of
how further processing is examined.
20 mins
If youre not completely comfortable with relevant costing attempt Q2 which looks at a minimum
price scenario. There are often marks for your assumptions as well as your calculations so
start to get in the habit of detailing why each item is / is not relevant. (This would take 20 mins)
Additional Resources - Study Text
Review section 7 (Chapter 1a) which looks at relevant costs in relation to accounting concepts.
5 mins
Read section 8 (Chapter 1a) to appreciate the qualitative factors involved in decision making.
5 mins
If your memory on joint costs is hazy read through section 9 (Chapter 1b). Joint costs / further
processing has been examined several times.
10 mins
15 mins
56
15 mins
CHECKPOINT 1
95 mins
Key areas - use the online lectures to selectively review these if you need to
The steps required in solving a linear programming problem.
Shadow prices
Course Notes
Work through the examples in this chapter again to ensure you are happy with these
techniques
Question Practice
Q4 (b) from the Question and Answer Bank in the back of the course notes will give you
additional practice of using this technique and the other types of requirement that can feature in
these questions. It is important to practice as many of these questions as you can, to become
quicker at what can be a time consuming technique.
Additional Resources
Study Text
Make sure you understand that a shadow price will only apply until that item ceases to be the
limiting factor. See section 3.1.3.
40 mins
45 mins
10 mins
35 mins
Key areas - use the online lectures to selectively review these if you need to
Addition of slack variables to produce equations
Interpretation of computer output
Course Notes
Review the three key elements in this chapter. Formulating the model, preparing the initial
tableau and interpreting the output from a linear programming package.
15 mins
Question Practice
Q5 in the Question and Answer Bank in the back of the course notes involves formulating a
model where slack variables are required. Attempt this to make sure you are comfortable with
the changes to the linear programming model that slack variables require.
10 mins
Additional Resources
Study Text
Review section 4 - Using linear programming, as these theoretical aspects could come into a
narrative requirement
10 mins
57
CHECKPOINT 1
Roger is considering undertaking a contract which will yield income of $15,000 over a 15-month period.
To carry out the contract he will have to use 1,000 kg of material. 800 kg is already held in stock and cost
$15 per kg. The current replacement cost is $20 per kg. If not used for the contract the material would be
sold to Moore Ltd for $2,000 in total.
Roger could utilise his old machine for the contract if conversion costs of $5,000 are undertaken.
Alternatively, he could scrap his old machine and receive $3,000 and hire another one at a cost of $500
per month.
Labour currently has spare capacity and variable overheads are estimated to be $1 per hour. 2,000 hours
are believed to be required for the period of the contract.
What is the net relevant cash flow for the contract? (Ignore the time value of money)
A
B
C
D
$2,000
$2,500
$4,000
$4,500
(2 marks)
Pobble plc is in the process of preparing a quotation for a special order. The job will require 255 units of
material M. 210 units, which originally cost $50 per unit, are in stock. Net realisable value per unit is $30
and replacement cost is $72 per unit. The only other use for the material is to use as a substitute for 375
units of material N which currently costs $25 per unit.
What is the relevant cost of material M for the special order?
(2 marks)
Top has limited factory capacity measured in labour hours and a decision must be made whether to make
or buy product X. Supplies of X can be purchased for $12 per unit. If X is made each unit costs $5 in raw
materials and requires 3 labour hours. Labour is paid at $1.50 per hour. Labour is currently working to
capacity making product Y which earns a contribution of $2 per unit, each unit needing 5 labour hours.
Which one of the following statements is true?
A
B
C
D
Top should be indifferent between making or buying X since the labour will be fully utilised in any
case
Top should make X because it is $3.50 per unit cheaper than purchasing
Top should buy X because it is $5.80 per unit cheaper than making
Top should make X because it is $1.30 per unit cheaper than buying X
(2 marks)
58
CHECKPOINT 1
Rhonda Bout Limited uses three components, P, Q and R, in its main product. The budget for next year
indicates a requirement for 3,000 of each component. The components are all manufactured on the same
machine, for which only 50,000 machine hours are available next year. The variable cost of internal
manufacture of each component, together with the machine hours used, are shown in the table below.
The table also shows the prices quoted by a sub-contractor for supplying the components.
Component
P
Q
R
Machine hours
per unit
9
5
12
Variable cost
$ per unit
45
70
56
Sub-contractor
price, $/unit
65
78
80
Calculate the minimum total cost at which Rhonda Bout can obtain the full requirement of components.
(5 marks)
5
When deciding, purely on financial grounds, whether or not to process a joint product, the information
required is:
(i)
(ii)
(iii)
(iv)
(v)
A
B
C
D
(2 marks)
A division of a firm has three product lines X, Y and Z. Last year's results are as follows:
Sales
Direct labour
Direct materials
Fixed overheads
Distribution costs
Selling costs
Fixed admin. overhead
Net profit/(loss)
X
$'000
220
(40)
(20)
(30)
(20)
Y
$'000
150
(20)
(80)
(15)
(50)
Z
$'000
130
(60)
(30)
(45)
(25)
(22)
(5)
83
(15)
(5)
(35)
(13)
(5)
(48)
No fixed overheads are directly attributable to a product line. The division's operations are independent of
the rest of the firm.
The overall firm's profit could be increased by closing down product line(s)
A
B
C
D
Y only
Z only
Y and Z
X, Y and Z
(2 marks)
59
CHECKPOINT 1
A company manufactures two products, S and T. Both products use the same type of resources, with the
following revenue/cost data per unit:
Selling price
Direct materials ($4/kg)
Direct labour ($6/hr)
Fixed overhead ($3/hr)
Profit
Product S
$40
Product T
$30
(8)
(18)
(9)
$5
(12)
(6)
(3)
$9
Only 15,000 kg of material are available in the short-term, compared with 20,000 labour hours. Maximum
demand for the products is 5,000 units and 2,000 units for S and T, respectively. The fixed overhead
absorption rate is based upon the maximum sales demand levels; none of the fixed overheads is
avoidable.
Calculate the maximum amount of profit (to the nearest $'000) that the company can earn.
(4 marks)
38,200
2.34
7.60
50
1,100
$171,900
430
180
PD Ltd has a number of options available to it to alleviate or avoid its limiting factor problems.
(i)
Purchase more of the factor associated with S2 from an alternative supplier at a price of $2.50.
(ii)
Alter the production process so that the factor associated with S1 can be used instead of that for
S2 and S3.
(iii)
Find an alternative supplier of the factor associated with S3, and pay up to $7.60 over the original
price.
All options
Options (i) and (iii)
Options (ii) and (iii)
Options (i) and (ii)
(2 marks)
60
CHECKPOINT 1
10
Hilliard enterprises use linear programming to establish their optimal production plan. Next year materials
and labour are likely to be in short supply.
Details of Hilliards products are as follows:
K
$
6
30
5
41
50
9
P
$
8
18
3
29
52
23
There are only 30,000 kg of material and 36,000 labour hours available. The company also has an
agreement to supply 1,000 units of product K which must be met.
Formulate the linear programming model that will maximise contribution. You are not required to attempt
a solution
(3 marks)
Explain why the financial profits may be different to the profits recorded on a relevant cost basis
(5 marks)
(4 marks)
The optimal solution that has been derived for company ABC shows that the shadow price for labour is
$7.33 and for material is $0.
Explain the relevance of these values for ABC
(4 marks)
61
CHECKPOINT 1
$
Revenue
Material:
200 kg $20
Scrap proceeds forgone
Machine:
Use old machine
Scrap old machine and hire another:
$3,000 (15 $500)
Labour:
Spare capacity
Variable overheads:
2,000 $1
Units
255
210
45
$
15,000
(4,000)
(2,000)
(5,000)
(4,500)
(4,500)
(2,000)
2,500
required
in stock
to purchase
$
3,240
9,375
12,615
$30 210
$25 375
NRV
Material N
$6,300
$9,375
$
Cost of making X
Raw materials
Labour (basic cost: 3 hrs at $1.50/hr)
Lost contribution ($2 3/5)
5.00
4.50
1.20
10.70
Cost of buying
Additional cost of buying
12.00
1.30
62
CHECKPOINT 1
This is a make-or-buy decision involving a limiting factor. If all of the components are
manufactured in-house, 78,000 machine hours will be required. Some sub-contracting will
therefore be necessary, since only 50,000 machine hours are available.
Costs can be kept at their lowest by minimising the extra variable costs of sub-contracting per
machine hour saved.
P
Q
R
$
$
$
Variable cost of manufacture
45
70
56
78
80
Sub-contractor price
65
Extra cost of buying
20
8
24
Machine hours saved by buying
9
5
12
Extra cost of buying per hour saved
$2.22
$1.60
$2.00
The priority for internal manufacture will be in the order: P, R, Q. This will minimise the extra cost
of buying per hour saved. The production and purchasing plan for components should therefore
be:
Hours used
Cost
$
Manufacture
27,000
135,000
3,000 P
( 9 hrs)
( $45)
107,296
22,992
( $56)
1,916 R
( 12 hrs)
49,992
Purchase
86,720
1,084 R (balance of requirement)
( $80)
($78)
234,000
3,000 Q
Minimum cost of satisfying component requirements
563,016
X
$'000
220
(60)
160
(10)
(22)
128
Sales
Direct costs
Variable distribution
Selling costs
Y
$'000
150
(100)
50
(40)
(15)
(5)
Z
$'000
130
(90)
40
(15)
(13)
12
Materials
10,000
6,000
16,000 kg
... materials are the limiting factor as only 15,000 kg are available.
S
$14
2
7
1st
Contribution/unit
Materials (kg) / unit
Contribution/kg
Rank
Produce
S
T
Units
5,000
1,666
63
T
$12
3
4
2nd
Kg
10,000
5,000
15,000
CHECKPOINT 1
10
Define variables.
=
=
=
The shadow price of $2.34 and $7.60 indicate the extra amount to pay for the resources.
Non-negativity constraint
p0
Workings
(1)
(2)
Section B
1
Financial accounts are prepared under an accruals basis. In other words, income and expenditure is
recorded in the period it relates to, not when cash is physically received or paid.
The financial accounts are also prepared according to absorption costing where an allocation of fixed
overheads is made to the cost of units.
Under relevant costing principles neither of these two items occur. Any costs that have already been
spent or committed to are excluded.
General overheads are not included as they occur regardless of whether or not the project being
assessed takes place.
Depreciation is not a cashflow and so would also be ignored on a relevant cost basis.
Not all variable costs will be deemed relevant. For example, if labour is not fully utilised, it can work on
the project without incurring additional cost and so labour would not be charged to the project.
Slack occurs when maximum availability of a resource is not used. ie we have 5,000 litres available 4,000
litres are used in production, so there are 1,000 litres spare or 1,000 litres of slack.
If, at the optimal solution, the resource used equals the resource available, the constraint is binding and
there is no slack .
Surplus is when more than the minimum requirement is made. ie there may be a requirement for
minimum production to be 1,000 units. If 1,200 units are made there are 200 surplus units.
64
CHECKPOINT 1
The shadow price is the extra contribution that would be achieved if one more unit of a limiting factor were
available.
The shadow price for labour here is $7.33. This means that we would be prepared to pay up to an extra
$7.33 ie $7.33 above the existing cost of labour/hour to obtain more of it. Labour is therefore a binding
constraint, it is restricting the amount of units we can make. If we had more labour we would be able to
make more units.
The shadow price for material however is $0. We would not pay any more than the existing cost of the
material to obtain more. This indicates that the material is not a binding constraint. We still have supplies
of material that are not used in meeting our optimal production plan.
65
CHECKPOINT 1
Can consumers eat a nutritious meal at McDonalds? This question fell to us as business students, not
nutritionists. We used powerful statistical tools to select a series of menus promoting health, variety and
consumer preference.
To solve this problem, we did what all good marketing students do: analysed customer needs. To quantify
nutritional requirements, we collected standards from the US Food and Drug Administration and the United
Nations. These standards vary according to height, weight, age, and activity level. We also collected nutritional
information on every product on McDonalds menu.
But this data is only enough to select one meal how boring. Consumers can go to McDonalds seven days a
week, for breakfast, lunch, and dinner. We wanted to choose a weeks worth of delicious selections. First, we
identified which selections were breakfast, lunch, and/or dinner options. We also identified items as beverages,
side dishes, entres, and desserts to create balanced meals and allowed consumers to express
preferences (more Big Macs, the number of sugars for coffee).
These decision criteria were defined mathematically and analysed using linear and goal programming. Linear
programming is frequently used in business, with complex algorithms driving supply chain management software
tools. Essentially, linear programming takes minimisation and maximisation conditions a little less sodium, a
little more vitamin C, trade that optional dessert for your favourite French fries to select the optimal outcome
meeting those conditions. If no optimum is possible, goal programming can be used to pick an alternative, and to
show how close to the optimal goal the choice is.
So how does McDonalds stack up? For the Editor of Career, no optimum menu was possible not enough iron,
too much sodium. Still, with our added intelligence, consumers can choose a much better menu, much closer to
nutritional goals than most people would expect. If only we had also designed an optimal exercise schedule.
These decision criteria were defined mathematically and analysed using linear and goal programming. Linear
programming is frequently used in business, with complex algorithms driving supply chain management software
tools. Essentially, linear programming takes minimisation and maximisation conditions a little less sodium, a
little more vitamin C, trade that optional dessert for your favourite French fries to select the optimal outcome
meeting those conditions. If no optimum is possible, goal programming can be used to pick an alternative, and to
show how close to the optimal goal the choice is.
So how does McDonalds stack up? For the Editor of Career, no optimum menu was possible not enough iron,
too much sodium. Still, with our added intelligence, consumers can choose a much better menu, much closer to
nutritional goals than most people would expect. If only we had also designed an optimal exercise schedule.
66
Multi-product breakeven
analysis
67
Overview
Breakeven analysis
CVP analysis
Single product
Multi-product
Normal
Distribution
68
Sensitivity
Analysis
Introduction
1.1
CVP analysis concerns the relationship between sales volume and profit.
1.2
Most businesses need to at least breakeven when setting prices and output levels.
Assumptions
1.3
Constant..
(a)
(b)
(c)
1.4
These lead to linear relationships for volume and sales revenue. This can also be described
as perfect competition.
2.1
Breakeven point =
Fixed costs
Unit contribution
Contribution/Sales ratio =
Breakeven revenue =
Contribution / unit
Selling price / unit
Fixed costs
C/S ratio
69
Introduction
3.1
A serious limitation of breakeven analysis is that it can only be used for single products.
This analysis can be expanded for a 'single' mix of products using a weighted average
contribution figure.
Formulae
3.2
Breakeven point =
Fixed costs
Weighted average unit contribution
Breakeven revenue =
Fixed costs
Weighted average C/S ratio
Lecture example 1
Footballs
$
7
3
2,000
(a)
(b)
Solution
70
Baseballs
$
6
4.50
4,000
Rugby balls
$
9
5
3,000
Sections 5 & 6
Target profits and
margin of safety
for multiple
products
71
Graphs
3.3
Graphs can also be used in multi-product situations to indicate the relationships between
cost, revenue and volume.
Lecture example 2
Required
Sketch a breakeven chart for Lecture example 1, indicating the profit at budgeted sales.
Solution
Workings
Budget
Units
Football
2,000
SP
$
7
Revenue
$
VC
Baseball
4,000
4.50
Rugby ball
3,000
Fixed costs
72
Costs
$000
Cost and
revenues
70
60
50
40
30
20
10
0
2,000
4,000
6,000
73
8,000
10,000 Output
volume
(units)
Multi-product P/V charts can also be produced which plot each of the products individually,
so allowing their profitability to be compared.
3.5
Lecture example 3
Required
Solution
Workings
Football
Revenue
$
14,000
VC
$
6,000
Baseball
24,000
18,000
Rugby ball
27,000
65,000
15,000
39,000
Cumulative revenue
$
Contribution
Cumulative profit
$
Football
Rugby ball
Baseball
74
C/S ratio
15
30
45
12,000
20,000
75
60
75
Revenue
$000
4.1
The assumptions in CVP about costs and revenues are all estimates and so cannot be
predicted with certainty.
4.2
However, if past experience enables the decision maker to predict with some accuracy the
probability occurring, the decision is said to be subject to risk.
4.3
Techniques such as probability and normal distributions enable risk to be accounted for.
Sensitivity analysis is a tool which can help deal with uncertainty.
Normal distribution
5.1
50
50
When using the normal distribution we will use the to define the mean and to define
standard deviation.
5.2
The total area under the curve = 1 or 100% of the population. The normal distribution is
always symmetrical around the mean. Consequently, the area either side of the mean
represents 50%.
5.3
Distances from the mean in the normal distribution are always measured by the number of
standard deviations they represent. This is known as a Z-score - the number of standard
deviations from the mean.
Z=
5.4
Normal distribution tables (given in the exam) give the relationship between % of
population and Z-score for any Z-score.
76
Lecture example 4
Technique demonstration
United Trading is now looking at making and selling cricket balls. The balls will be sold for $7 each
and incur variable costs of $4. Fixed costs are expected to be $9,000. United Trading expect
mean demand to be 3,500 units, They anticipate that sales will be normally distributed with a
standard deviation of 400 units.
Required
Solution
77
Lecture example 5
Technique demonstration
United Trading is now looking at making and selling cricket balls. The balls will be sold for $7 each
and incur variable costs of $4. Fixed costs are expected to be $9,000. United Trading expect
mean demand to be 3,500 units, They anticipate that sales will be normally distributed with a
standard deviation of 400 units.
Required
Calculate the probability of the cricket balls making at least $2,500 profit.
Solution
78
Sensitivity analysis
6.1
Sensitivity analysis is a technique where decision options are tested for their vulnerability to
changes in a variable.
6.2
6.3
(a)
Calculating the maximum percentage change in a variable before the decision would
change.
(b)
Sensitivity analysis concentrates management attention on variables that are the most
important for the decision under review.
Lecture example 6
Technique demonstration
$ /unit
120
30
25
(a)
Calculate the impact on the margin of safety if material costs increase by 5%.
(b)
Calculate the maximum % increase in fixed costs possible that will still allow Columbus to
break even (assuming material is $30 / unit)
Solution
79
80
Chapter summary
Section
Topic
Summary
CVP analysis
assumptions
Single product
breakeven analysis
Breakeven point =
Multi product
breakeven analysis
Fixed costs
contribution/unit
Fixed costs
Weighted average contribution/unit
Normal distribution
Sensitivity analysis
81
END OF CHAPTER
82
Pricing decisions
83
6: PRICING DECISIONS
Overview
Pricing decisions
Nature of the
Product Life Cycle
Price elasticity
%x
%P
Demand function
P = a bx
Optimal pricing
Profit
MR = MC
84
Revenue
MR = 0
6: PRICING DECISIONS
Pricing decisions
Approaches and strategies
Cost plus
Full cost
Marginal cost
Relevant cost
Mark-up
Margin
New products
Penetration
Skimming
85
Other
Premium
Discrimination
Differentiation
Product bundling
Loss leaders
Controlled pricing
6: PRICING DECISIONS
Price elasticity
1.1
Economic theory states that the higher the price charged the less demand there will be for
normal goods.
1.2
1.3
PED is calculated =
% change in x
% change in P
Section 2 Other
issues that
influence pricing
decisions
Availability of substitutes
Disposable income
Tastes and fashions
Necessities or luxuries
2.1
The PLC determines the volume of a good or service demanded over time.
2.2
As sales volumes vary over time, it follows that profits are also likely to change.
2.3
$ Development
Introduction
Growth
Maturity
Decline
Revenue
TIME
Profit
86
6: PRICING DECISIONS
2.4
Stage
Sales Volume
Development
None
Introduction
Growth
Rapid increase
Maturity
Decline
Falling demand
Demand function
3.1
Price will affect the quantity demanded for a product. Output considerations will alter the
price to be charged. If the demand function is known, and the desired output has been
calculated, the appropriate price can be determined for the product.
3.2
Demand functions are usually downward sloping demand falls when price rises and vice
versa due to the fact that the market is usually one of imperfect competition.
($) P
X (units)
Tabular approach
Algebraic approach
For the algebraic approach it is necessary for the demand function to be in the form
P = a - bx
P
selling price
theoretical maximum price. If price is set at 'a' or above, demand will be zero
change in price
change in quantity
87
6: PRICING DECISIONS
Optimal pricing
4.1
The desired level of output can be determined graphically by plotting total cost and total
revenue lines. This is another breakeven chart, as used by economists.
$
TC
MR
Profit
TR
MC
Optimal output
4.2
The gradient of the total revenue line is known as the marginal revenue (MR). It is the
increase in total revenue from selling one more unit.
4.3
The gradient of the total cost line is known as the marginal cost (MC). It is the increase in
total cost from producing one more unit.
4.4
This analysis can be used to ensure the company reaches its objective.
4.5
Profit is maximised where the gradients are equal, ie where marginal revenue = marginal
cost.
4.6
Revenue is maximised when the slope of the revenue curve is flat ie where MR = 0.
$
MR
TR
X
Optimal output
88
6: PRICING DECISIONS
Step 2
Step 3
Substitute the values found for a and b in step 1 into the MR formulae and solve.
Step 4
Take the quantity found in step 3 and put this into the demand function to find the
price that should be charged
Lecture example 1
A firm charges $12 per unit for its product. At this price it sells 16,000 units.
Research has shown that when prices were changed by $1 per unit sales changed by 2,500 units.
The product has a constant variable cost per unit of $5.
The demand function is given by P = a bx. The marginal revenue will be MR = a 2bx.
Required
(a)
(b)
(c)
(d)
Solution
89
6: PRICING DECISIONS
Q6 Optimal
Pricing
90
6: PRICING DECISIONS
Tabular approach
4.7
One approach to determining the profit maximising production plan is to calculate the extra
(marginal) costs and revenues at different combinations of output and selling price.
Lecture example 2
Preparation question
Output
(Units)
10
Total
Cost
$
10
20
25
4.50
30
45
4.00
40
70
3.50
50
100
3.00
60
135
2.50
MC
$
Selling
Price
$
5.00
Total
Revenue
$
MR
$
Profit
$
Required
Determine the output level and selling price that will maximise profit.
4.8
A tabular approach assumes that only discrete variables exist, ie that either 30 or 40 units
can be sold, not, say, 35. The use of equations can solve this problem.
4.9
Tabular approaches can be used in all circumstances. Equations will only be tested in P2
when the demand function is linear.
Practical pricing
5.1
91
6: PRICING DECISIONS
The price of the product is calculated by adding an appropriate profit mark-up to the
product's cost. The cost used could be:
Strategy
Advantages
Disadvantages
Easily calculated
Full / Absorption
Readily determined
Doesn't require or assume
a linear and stable price or
quantity relationship
Marginal
Relevant cost
Standard cost
92
6: PRICING DECISIONS
Market penetration
6.1
A policy of low prices when the product is first launched to obtain sales volume and
market share.
6.2
Useful if:
(a)
(b)
(c)
Market skimming
6.3
Involves charging high prices when a product is first launched and spending heavily on
advertising and sales promotion to obtain sales. As the product moves into the later stages
of its life cycle (growth, maturity and decline) progressively lower prices will be charged. The
aim of market skimming is to gain high unit profits early in the product's life.
6.4
Useful if:
Pricing strategy
leaves room for
discounts later
(a)
the product is new and different, so that customers are prepared to pay high prices
to be 'one up' on people who do not own it.
(b)
the product has a short life cycle and needs to recover development costs and make
a profit quickly.
Premium pricing
7.1
Making a product appear 'different' so as to justify a premium price. The product may be
different in terms of quality, reliability, durability, after-sales service or extended warranties.
Heavy advertising can establish brand loyalty which can help to sustain a premium.
Price discrimination
7.2
New laws to stop
British internet
price rip offs
When a company can sell into two or more separate markets, it might be able to charge a
different price in each market. To be successful the company must prevent the transfer of
goods from the cheap market to the more expensive one.
Product differentiation
7.3
Different versions of products enable a higher price to be charged, optional extras may be
one way of achieving this.
93
6: PRICING DECISIONS
Product bundling
7.4
Selling a number of products or services as a package at a price lower than the aggregate
of their individual prices.
Loss leaders
7.5
Particularly useful in retailing, a very low price is charged for one product, which is intended
to make consumers buy additional products in the range that carry higher profit margins.
Controlled pricing
7.6
Monopolies have the potential power to charge very high prices for their goods/services as
demand is inelastic. Frequently monopolies are regulated to ensure customers receive value
for money.
94
6: PRICING DECISIONS
Chapter summary
Section
Topic
Summary
Price elasticity
The product
lifecycle
Demand function
P = a bx
Where P = price
x = quantity demanded
a = price at which demand is nil
b = amount by which the price must fall to sell
one more unit of the product
4
Optimal pricing
Other pricing
strategies
95
6: PRICING DECISIONS
END OF CHAPTER
96
Cost planning
97
7: COST PLANNING
Overview
Cost planning
Learning curves
Formula
Theory
Calculating the
learning rate
Steady state
Conditions
98
7: COST PLANNING
Overview
Cost planning
Value analysis
Target costing
Functional analysis
99
7: COST PLANNING
1.1
Calculating costs of established products and services made using established methods is
relatively straightforward. Standards and budgets can be set.
1.2
Costing new products and services is inherently uncertain. Modern business environments
tend to:
be highly automated
have short production runs
involve short product life cycles
hold lower levels of inventory
1.3
Introduction
2.1
When new working practices or products are introduced, the theory is that as a workforce
gains experience in a task, it will come to perform that task more quickly.
This means that labour costs and variable overheads (if labour hour driven) will be lower in
later periods of production than initial periods.
Conditions
2.2
The theory of learning curves will only hold if the following conditions apply:
(a)
(b)
(c)
(d)
(e)
(f)
Rule
2.3
Section 1.7 The
relevance of
learning curve
effects in
management
accounting
As cumulative output doubles, the cumulative average time per unit falls to a given
percentage of the previous cumulative average time per unit.
100
7: COST PLANNING
2.4
Formula
2.5
Yx= aXb
where Yx
a
X
b
Steady state
2.6
Eventually, the time per unit will reach a steady state where no further improvement can
be made.
101
7: COST PLANNING
Lecture example 1
Total time
(hours)
Required
If the budgeted time for the first batch is 100 hours, calculate the time needed to produce the
following.
(a)
(b)
(c)
Solution
102
7: COST PLANNING
The actual learning rate achieved may not be the same as that expected. You could be
asked to calculate the actual rate of learning in the exam and to comment on why this may
be different to the expected learning rate.
Lecture example 2
(a)
(b)
Solution
Q7 Learning
curves 2
103
7: COST PLANNING
3.1
Life cycle costing aims to cost a product, service, customer or project over its entire life
cycle with the aim of maximising the return over the total life while minimising costs.
3.2
Traditional accounting relates costs and revenues to time periods (months, years). This
makes it difficult to see total profitability.
3.3
Product life cycle costing considers all the costs that will be incurred from design to
abandonment of a new product and compares these to the revenues that can be generated
from selling this product at different target prices throughout the product's life.
3.5
3.6
Characteristics
Costs
Development No sales
Introduction
Growth
104
7: COST PLANNING
Stage
Characteristics
Costs
Maturity
(a)
(b)
(c)
90% of costs to be incurred throughout its life cycle will have been determined before
a product reaches the market.
There are a number of ways that return can be increased over the life cycle.
(a)
Approximately 70% 90% of a product's life cycle costs are determined by decisions
made early in the life cycle at the design and development stage. Thus design and
production teams must work together to ensure costs are minimised.
(b)
This is the time from the conception of the product to its launch. If a company can get
a product to the market place very quickly, it will give the product as long a span as
possible without competitors' rival products in the market place. This should mean
that market share is increased in the long-run.
(c)
Pricing strategies will affect both contribution and volumes generated. This will
thereby affect learning.
(d)
For example, product development, finding other uses for a product or staggering the
launch of the product in different markets.
105
7: COST PLANNING
Advantages of LCC
3.10 (a)
(b)
Considers all costs incurred on a product, and therefore leads to cost reduction.
(c)
Very useful in the modern competitive environment, in which products often have
a short life cycle and when a large portion of costs will be committed prior to
commencing production.
3.11 Life cycle costing can also be used for customers. This is particularly useful in service
businesses where significant costs may have been incurred to win a contract.
Implications
3.12 Given that there will be different levels of demand for a product over its expected life, it
would not be appropriate to set one price for the product's entire life.
3.13 An understanding of the stages a product goes through enables you to price accordingly to
either manipulate demand (low price, demand will rise and the intro stage is shortened) or to
maximise profit.
3.14 All costs relating to a product including R&D are associated with the product. This enables
true assessment of a products profitability.
3.15 Having looked at a products PLC it is clear that initially the product will make a loss.
Viewing profitability on a periodic basis can put unnecessary pressure on management due
to the visibility of the loss and could lead to wrong decisions being taken.
Growth
Maturity
Decline
Product
Undifferentiated
Higher quality
New features
Reduce/rejuvenate
Price
High market
skimming
Falling to
stimulate
demand
Falling price
war
Low to shed
surplus stock
Intensive
New channels
Selective
Differentiate
Create switching
costs
Reduced
or low market
penetration
Place
Selective
106
High if niche
market
7: COST PLANNING
Lecture example 3
Preparation question
Co X are in a high tech industry and are often first to market with new technological advances.
They have recently spent $500,000 designing and developing a new product. The new product is
expected to have an eighteen month lifecycle.
The anticipated performance of this product is as follows:
Introduction Growth
Sales volume (units)
4,000
9,000
Per unit ($)
Selling price
599
549
Variable Cost
249
249
Overhead
100
100
Required
Solution
107
Maturity
30,000
Decline
10,000
449
199
60
349
149
75
7: COST PLANNING
Target costing
4.1
As product life cycles have become much shorter, the planning, development and design
stage of a product is critical to an organisation's cost management process. Cost reduction
must be considered at this stage of a products life cycle, rather than during the production
process.
4.2
Target costing involves setting a selling price for your product by reference to the market.
From this your desired profit margin is deducted leaving you with a target cost.
Cost
(1st)
Target Costing:
mark-up
(2nd)
selling price
(1st)
target
cost
(3rd)
108
7: COST PLANNING
Define
current
cost
Define
sales
volume
Define
product
specification
Define
investment
Define
required
profit
Set
target
price
Calculate
cost gap
Define
target
cost
Try to
close
cost gap
Mercedes Benz
and target costing
(a)
(b)
Set a target selling price at which the company will be able to achieve the desired
market share.
(c)
(d)
The estimated cost of the product is calculated based on the product specification
and current cost levels.
(f)
(g)
Efforts are made to close the cost gap. Aim to design out costs before production
starts and determine whether the project will go ahead.
4.6
Target costing aims to reduce the life cycle costs of new products, while ensuring
quality, availability, and other consumer requirements, by examining all possible ideas for
cost reduction at the product planning, research and development and the prototyping
phases of production.
4.7
Target costing does not cease once an item has gone into production. Costs are continually
monitored to ensure the target is being achieved. If the target cost is being exceeded by a
significant amount, Value Analysis will be employed. (section 5)
109
7: COST PLANNING
4.8
Relationship between
product concept, cost and
price
Predetermined product
design
Cost
Price
Target costing
Selling price
Profit margin
Target cost
110
7: COST PLANNING
Lecture example 4
Preparation question
Sam produces rabbit hutches. He is about to launch a new top of the range hutch which he
believes he can sell for $125. He demands a margin of 25% on sales.
Cost information for the new hutch is as follows:
Timber Good quality timber is essential the hutch needs 10m of good quality planed timber.
Sam can acquire this at a cost of $48.
Felt roofing material 2m2 are required. Roofing material costs $17.50 / m2
Wire 1m of wire is needed at a cost of $1.50 per metre
There is some uncertainty about the amount of time needed to construct the hutch. Estimations for
the labour time needed are:
1 hours 0.25 chance
2 hours 0.5 chance
2 hours 0.25 chance
Labour is paid at a rate of $7 / hour
Variable overhead These will be incurred at a rate of $1.50 per labour hour
Required
Calculate the target cost of the new hutch and identify any cost gap that may exist
Solution
111
7: COST PLANNING
Value analysis
5.1
Value analysis is 'a systematic inter-disciplinary examination of factors affecting the cost of a
product or service, in order to devise means of achieving the specified purpose, most
economically, at the required standard of quality and reliability'.
5.2
Value analysis encourages innovation and seeks to maintain the value of the product to the
customer by any production method possible.
5.3
Cost value
Exchange value
Use value
Esteem value
reduce
maintain or improve
Only value adding activities should take place ie those activities which create, or enhance,
the quality of saleable products.
5.5
5.6
(b)
(c)
(d)
(e)
Functional analysis
6.1
6.2
6.3
7: COST PLANNING
6.4
Functional Analysis
When used
During production
Prior to production
Focus on
Customer value
Involves
113
7: COST PLANNING
Chapter summary
Section
Topic
Summary
Managing future
costs
Learning curve
theory
Lifecycle costing
Target costing
Value analysis
Functional
analysis
END OF CHAPTER
114
Cost analysis
115
8: COST ANALYSIS
Overview
Absorption costing
One OAR
Activity-based costing
Cost pools
Cost drivers
Unit
Batch
Product
Facility sustaining
Cost analysis
Activity-based management
Customer profitability
analysis
Distribution channel
profitability
Pareto analysis
116
Direct product
profitability
8: COST ANALYSIS
Overview:
Part 1 brought forward knowledge
Cost analysis
Absorption costing
One OAR
Activity-based costing
Cost pools
Cost drivers
117
Unit
Batch
Product
Facility sustaining
8: COST ANALYSIS
1.1
Traditional absorption costing uses a single basis for absorbing all overheads into cost
units for a particular production department cost centre.
PRODUCTION SET-UP COSTS
MACHINE OIL
PRODUCTION
DEPARTMENT A
OAR
= One OAR
SUPERVISORS' SALARIES
MACHINE REPAIRS
Activity-based costing
2.1
Production overheads are by no means all volume-related and hence a single basis for
absorption, eg labour hours, would not adequately reflect the complexity of producing
certain products/cost units as opposed to others.
2.2
ABC is an extension of absorption costing specifically considering what causes each type of
overhead category to occur, ie what the cost drivers are. Each type of overhead is absorbed
using a different basis depending on the cost driver.
Activities
PRODUCTION
SET-UP COSTS
Cost drivers
No. OF PRODUCTION
SET-UPS
MACHINE HOURS
LABOUR HOURS
SUPERVISOR'S
SALARY
OAR
OAR
OAR
Steps in ABC
2.3
Met spending
122m on
paperwork
(a)
Group overheads into cost pools, according to how they are driven.
(b)
Identify the cost drivers for each activity ie what causes the activity cost to be
incurred.
(c)
(d)
118
Multiple
OARs
8: COST ANALYSIS
Lecture example 1
Tufty Toerags is a company that makes rolls of carpets in standard widths of 4 metres which come
in standard lengths of 30 metres. Over 15 years ago the machines used required a lot of manual
operation and the company had established a costing system based on direct labour absorption of
its fixed overhead.
The company has two products, the Twist (a 50% wool/50% polypropylene mixture) and the
Supertwist (an 80% wool/20% polypropylene mix).
Twist
15,000
$/m2
8.99
$/roll
360
180
3
Supertwist
20,000
$/m2
12.99
$/roll
576
72
4
$
5,000,000
4,750,000
5,500,000
3,500,000
18,750,000
Twist
400
15
Supertwist
150
10
Tufty Toerags is considering changing from traditional absorption costing to ABC to calculate the
cost of its carpets.
The total unit cost under absorption costing per m2 is $8.275 for the Twist and $10.43 for the
Supertwist.
Required
(a)
Assuming machine and labour hours are the same, calculate the total unit cost per m2 for
each product using ABC.
(b)
Calculate and comment on the profitability of each product and suggest any changes that
could be made, together with any reservations you may have.
119
8: COST ANALYSIS
Solution
120
8: COST ANALYSIS
121
8: COST ANALYSIS
2.4
Uses of ABC
The use of ABC provides the following opportunities.
2.5
2.6
(a)
(b)
(c)
(d)
(e)
A more realistic estimate of costs and profits which can be used in performance
appraisal
(f)
Better pricing
(g)
Criticisms of ABC
(a)
(b)
(c)
(d)
(e)
(f)
When production overheads are high relative to prime costs (eg service sector)
(b)
(c)
(d)
122
8: COST ANALYSIS
3.1
Today's complex business environment means that costs are incurred because cost drivers
occur at different levels.
3.2
There are four key categories for activities and their related costs.
Categories
Type of cost
Cost driver
Unit
Direct
Units produced
Batch
Set ups
Inspection
Batches produced
Product
R&D
Maintenance
Products produced
Facility sustaining
Depreciation
Rent
None
The difference between unit costs under absorption costing and ABC depends upon the
proportion of overhead in each category.
If most overheads are unit level or facility sustaining the costs will be very similar.
If overheads are batch or product sustaining costs, the resulting costs may be very different.
123
8: COST ANALYSIS
124
CHECKPOINT 2
Take some time to reflect on the knowledge and skills you covered during Stage 2. If you feel you need further
clarification on any of the key areas listed below you can use the on-line lecture for the relevant chapter. The
Course Notes section for each chapter (starting overleaf) provides helpful guidance (and time commitments) on
how to focus your review on the key learning points in your notes.
Key knowledge
Pricing
Optimal pricing and the demand function are regularly examined. Students often find this difficult initially but once
they have grasped the steps involved can handle these questions well.
Remember:
Step 1 - Solve the demand function. Then state this with the values you have discovered for a and b.
Step 2 - If profit maximisation is required make the MR equation given = MC. If revenue maximisation make
MR = 0.
Step 3 - Substitute the values found for a & b in step 1 into this formulae and solve.
Step 4 - Once MR = MC/0 is solved take the quantity found and put this into the demand function to find the
price that should be charged to obtain the profit/ revenue maximising quantity.
Dont forget this exam does not just include numbers but also a significant proportion of written answers.
Discussion on pricing strategies for new products is also frequently examined. Make sure you understand the
various pricing policies and, particularly for cost plus, can discuss the various advantages and disadvantages.
Learning curves
This is another topic that is examined regularly. It is important that you can use the formula to calculate the total
time for production and the time taken to produce the nth unit. Make sure you practice these calculations and can
list the conditions for the learning curve to exist as these may form part of a discussion piece in this area.
Lifecycle and target costing
These techniques can be examined via numbers but are equally if not more likely to be examined via words so
ensure you can recall the principles of each.
Key skills
It is important that as well as getting to grips with the knowledge gained in stage 2 you give sufficient attention to
the key skills you need in order to score well on numerical questions. You must aim to:
Learn the steps involved in optimal pricing and learning curve calculations so that you can reproduce
them quickly and accurately in the exam.
Start to think about getting the easy marks For example in an investment appraisal put in the
investment, residual value and discount rates first, then sales or costs that dont involve or have simple
workings leaving the more involved items until last.
As with all numerical questions, continue to lay out your answers clearly and cross-reference all your
workings. This will help you to pick up additional marks in the exam the marker can reward you for
correct technique even if you make some mathematical errors.
125
CHECKPOINT 2
35 mins
Key areas - use the online lectures to selectively review these if you need to
Course Notes
Rework lecture examples 1 & 3 to ensure you are happy with this technique.
Additional Resources
Study Text
There are several examples in here which are useful to work through should you have the
time.
20 mins
15 mins
30 mins
Key areas - use the online lectures to selectively review these if you need to
Optimal pricing
Course Notes
Rework the optimal pricing calculations in Lecture Example 1 as these are frequently
examined. It is important that you are comfortable with the steps involved in solving these
problems.
10 mins
Question Practice
Attempt Question 6 from the Question and Answer Bank in the back of the Course Notes using
your Notes to help if necessary. Optimal pricing is an area that features regularly in the P2
exam so it is important you get to grips with it as soon as you can.
10 mins
Additional Resources
Real-life examples
At the end of this checkpoint you will see two articles that look at pricing. One looks as how
Sony use price skimming and the other looks at price discrimination. It is strongly
recommended that you review these articles to aid your practical understanding of these
techniques
Study Text
It is recommended that you read section 2 to add to your knowledge of issues that influence
prices.
126
5 mins
5 mins
CHECKPOINT 2
50 mins
Key areas - use the online lectures to selectively review these if you need to
Course Notes
Lecture examples 1 & 2 should be reviewed as learning curves are frequently examined.
15 mins
The other aspects in this chapter tend to be examined in discussion questions. Review these
techniques to ensure you fully understand them and their implications.
10 mins
Question Practice
Attempt Question 7 from the Question bank in the back of your course notes. Learning curve
calculations tend to feature very regularly in the exam so its important to ensure you are
comfortable with them.
20 mins
Additional Resources
Real-life examples
At the end of this checkpoint you will find an article that reviews how Mercedes-Benz uses
target costing. It is strongly recommended that you read this article.
Study Text
Read section 1.7 which looks at the uses of the learning curve in management accounting. (5
mins)
5 mins
20 mins
Key areas - use the online lectures to selectively review these if you need to
Course Notes
Review sections 1 - 3 to ensure you can recall the technique and uses of ABC.
10 mins
5 mins
Additional Resources
Study Text
Review section 1.2 for information on the costs of volume versus variety.
Real-life examples
At the end of this checkpoint you will see an article that looks at the information the
metropolitan police collect using ABC. (Reading the article would take a couple of mins)
5 mins
127
CHECKPOINT 2
J Ltd produces and sells two products. The O sells for $12 per unit and has a total variable cost of $7.90,
while H sells for $17 per unit and has a total variable cost of $11.20. For every four units of O sold, three
of H are sold. J Ltd's fixed costs are $131,820 per period. Budgeted sales revenue for the next period is
$398,500.
What is the margin of safety (in $)?
(3 marks)
A company makes and sells three products A, B and C. The products are sold in the proportions
A:B:C = 1:1:4.
Monthly fixed costs are $55,100 and product details are as follows:
Product
A
B
C
Selling price
$ per unit
47
39
28
Variable cost
$ per unit
25
20
11
The company wishes to earn a profit of $43,000 next month. What is the required sales value of product
A in order to achieve this target profit?
(3 marks)
3
A company sells three different types of training course to its customers: Weekend, Day-release and
Evening. Selling prices, unit costs and monthly sales are as follows:
Weekend
Day-release
Evening
$
$
$
Selling price
120
110
95
Variable cost
55
40
50
Monthly sales
40
30
20
Calculate the average contribution to sales ratio of the company.
(i)
(ii)
if the total number of monthly sales remains the same, but equal numbers of each course are
sold.
(4 marks)
128
CHECKPOINT 2
P = 1,000 0.025Q
P = 1,000 0.0125Q
P = 50 0.025Q
P = 500 - 0.0125Q
(2 marks)
$125
$225
$375
$500
(2 marks)
NRC Ltd makes and sells a single product X. The selling price and marginal revenue equations for
product X are as follows:
Selling price = $60 - $0.001Q
Marginal revenue = $60 - $0.002Q
The full cost of X is $35 per unit. Fixed costs are $150,000 and it was originally budgeted to make 15,000
units.
In order to maximise profit, what should be the selling price per unit?
(2 marks)
Current demand for Orchards product the Russet is 5,000 units each year, its selling price is $175. For
every $10 that the selling price is increased demand for the Russet falls by 500 units. Marginal cost for
the Russet is $65. What price will Orchard need to set in order to maximise profits?
Note: If price P = a bx then MR = a 2bx
(3 marks)
3
4
5
6
7
8
9
Product P
3,000 units
$ per unit
12
3
15
2
8
3
30
17
129
Product Q
2,000 units
$ per unit
11
6
17
1
1
2
2
5
3
Product R
1,500 units
$ per unit
8
2
10
1/
3
2
10
10
15
20
Total
$70,000
$24,000
$94,000
20
15
50
40
$
71,500
10,500
35,000
22,500
25,500
165,000
CHECKPOINT 2
Indirect production overheads that are not driven by production volume are:
Item
Set-up costs
Materials handling
Packing
Engineering
Cost driver
Production runs
Deliveries of materials
Deliveries to customers
Production orders
What would be the full production cost per unit of product R if overheads are absorbed on the basis of
direct labour hours?
A
B
C
D
$13.75
$23.75
$30.00
$51.25
(2 marks)
Calculate the full production cost per unit of product R using activity-based costing and the cost drivers
described above, with overheads that are driven by production volume absorbed on a machine hour
basis.
(4 marks)
10
A company has produced the first batch of a new product which took 40 hours to manufacture. With an
80% learning curve, how long would it take to make the next nine batches?
(2 marks)
11
The time taken to produce the first unit of a new product was 12 hours. By the time four units had been
made, the average time per unit had dropped to 6 hours. What was the rate of learning experienced?
(2 marks)
12
KJ has recently developed a new product. It is usual for the workforce to experience an 80% learning
effect as the work is repetitive. It takes 3 kg of material at $4/kg to produce each unit and variable
overheads are expected to cost $2.50/hr. Labour is paid $8/hr.
If the first unit took 40 minutes to produce, what will be the expected cost of the fifth unit?
(4 marks)
Why is cost plus pricing not recommended for new products and what pricing strategies would be
appropriate instead?
(5 marks)
What is the learning curve theory and what are the conditions for it to exist?
(3 marks)
130
(5 marks)
CHECKPOINT 2
$(12 7.90)
$(17 11.20)
=
=
$4.10
$5.80
B/E Rev
4
15,595
12
187,140
3
11,697
17
198,849
7
27,292
385,989
Margin of safety
Budgeted sales breakeven sales = $(398,500 385,989) = $12,511
O
H
(i)
Weekend
$
65
2,600
4,800
5,600
= 56%
10,000
131
Day-release
$
70
2,100
3,300
Evening
$
45
900
1,900
Total
$
5,600
10,000
CHECKPOINT 2
(ii)
When courses are sold in equal numbers, they are sold in the ratio 1:1:1. Calculations can be
performed on this ratio basis.
Weekend
$
65
120
Contribution
Sales
180
325
= 55.4%
P = a bQ
20
1,600
= -0.0125
b=
P = $1,000 0.0125Q
P = $1,000 (0.0125 x 50,000)
P = $375
Marginal cost
$35
$25
$150,000
15,000
= MC
$60 $0.002Q
= $25
= 17,500
Selling price
$42.50
132
Day-release
$
70
110
Evening
$
45
95
Total
$
180
325
CHECKPOINT 2
P = a bx
b = 10/500 = 0.02
175 = a 0.02 5,000
175 = a 100
a = 275
P = 275 - 0.02 x
Maximise profits when MR = MC
65 = a 2bx
65 = 275 0.04x
210 = 0.04x
x = 5,250
P = a bx
P = 275 0.02 5,250
P = 170
B
Direct labour hours
P
Q
R
= $165,000 4,000
= $41.25 per direct labour hour.
3,000
2,000 1
1,500 1/3
= 1,500
= 2,000
= 500
4,000
Overhead rates
Machining
Set-up costs
Materials handling
Packing costs
Engineering
Product R overhead costs
Machining
Set-up costs
Materials handling
Packing costs
Engineering
Cost per unit of R
Direct materials
Direct labour
Overhead
133
CHECKPOINT 2
10
y = axb
b=
log 0.8 _
= 0.3219
log 2
y = 40 10-0.3219
y = 19.062 hours
Time for all 10 batches
10 19.062
less: time for first batch
Time for 9 batches
191
(40)
151 hours
11
Units
12
12
12r2
6
12
0.707
70.7%
axb
40 5-0.3219
23.825 mins
log 0.8 _
= 0.3219
log 2
119.13
40 4 -0.3219
25.6 mins 4 units
Time for 5th unit
Cost
Materials
Labour
Variable overheads
Total cost of
5th
102.40
16.73
3 kg $4/kg
$
12.00
16.73 mins
2.23
8
60
2.50
16.73 mins
60
unit
134
0.70
14.93
CHECKPOINT 2
Section B
1
% change in x
% change in P
If the elasticity of a product is greater than 1 it is said to be elastic. Small changes in price will drive large
changes in quantity demanded.
If the elasticity is less than 1 this is inelastic. Changes in price do not cause large changes in demand.
2
Cost plus pricing is not generally suitable for new products because the cost of the product is not known
with certainty. Costs are likely to fall as volumes rise and as learning is experienced and so selecting a
suitable cost basis is difficult.
Either a strategy of market penetration or market skimming tends to be used instead.
Market penetration is the policy of setting a low price in order to gain sales volumes. This enables the
early stages of the product lifecycle to be shortened as volumes grow quickly. This low price also may
discourage competitors entering the market.
Market Skimming is where a high price is set in order to gain high unit profits. Companies which produce
goods with advanced technology and therefore have high development costs tend to choose market
skimming. They will tend to then lower the price as the product moves through the stages of the lifecycle.
Learning curve theory states that as cumulative output doubles, the cumulative average time per unit falls
to a given percentage of the previous average time per unit .
The conditions for it to exist are:
135
CHECKPOINT 2
Pricing strategy will be a key issue for Sony's PlayStation 3 console, which enters the European market as by far
the most expensive of the new generation of games consoles - priced at 599 ($799), compared with about 250
for Nintendo's Wii and 300 for a basic version of the XBox 360.
Sony justifies the price by arguing the PS3 is not just a games console but a "home entertainment hub" that can
connect to the internet, display photos, play music and includes a high-definition Blu-Ray disc player, retail prices
for which start at about 500 ($980). At the same time, it is clear Sony is positioning itself for price cuts later in
the year.
European PlayStation fans were outraged last month when Sony announced they would not be able to play
many of their PlayStation 2 games on the new PS3 because the company had removed the microchip that
enabled backwards compatibility.
Alex Kwiatkowski, analyst at Datamonitor, said removing the chip would make it easier for Sony to cut prices
before Christmas.
Overall Sony is thought to be planning to halve the number of components.
The PS3 prototype had 4,000 [components] but now a shift to 2,000 is in the pipeline, said Yuji Fujimori, analyst
at Goldman Sachs. "Past history shows that a halving of the price results in quadrupled volumes." He expected a
100 price cut before Christmas and a further 50 before Christmas next year as a result of cutting the
component numbers.
He said the price cuts would result in a wider operating loss to Y70bn ($592m) from Y60bn at Sony's games unit
in the fiscal year starting April 1.
Companies will be prevented from charging British consumers more than foreign residents for buying the same
products or services over the telephone or internet under a proposed European law supported by Tony Blair.
The measure will affect many airlines, car hire firms, travel agents and electrical goods firms that discriminate
against Britons with higher prices.
The European commissions proposals will be discussed by trade ministers later this month and are expected to
become law next year.
Currently, some companies particularly when consumers buy online or over the phone ask for a country of
residence. Those living in different European Union countries are then charged different prices. Last week
British Airways was charging customers in Britain twice as much as those on the Continent for the same flight.
Other companies such as Hertz car rentals and Thomas Cook also charged more to British residents.
Under the new measure, variable pricing will not be banned but Britons will be entitled to pay the lowest prices
available to other EU residents. They may still have to pay higher postal charges and the tax charged could vary.
It is hoped that, as people learn of their new rights, firms will be forced to cut prices so they are consistent
throughout the EU.
A spokesman for the commission said: The proposal is to break down barriers and outlaw the practice of
charging different prices for the same service in the EU. Consumers will benefit and enjoy the advantages of the
single market.
The Department for Trade and Industry said yesterday it supported the plan and would publish its consultation
paper on the scheme later this month.
136
CHECKPOINT 2
Last week British consumers booking a luxury trip to New York over the internet had to pay almost twice as much
as French residents for the same flights and hotels.
A business class British Airways seat costs British residents $2,353 compared with $1,071 for the French on
the same flight from Paris via Heathrow.
Three days basic car hire from Hertz costs Britons $129.05 but French travellers pay $108. Three nights at the
Sofitel hotel in New York, booked with Thomas Cook, costs $1,074 for Britons but just $801 if you live in France.
Kate Cowper, 26, from Nottingham, said she welcomed the plan after falling foul of differential pricing. She said:
I booked a car on an Italian website off Hertz but when I arrived I was told that I had to pay almost twice as
much because I was British. I contested the higher fee but the contract I had signed meant they just took the
money from my credit card.
Similar differential pricing is also used by Sony and other electronics firms. British consumers using Sonys
website are charged $278 more for VGNA217M laptop computers than Spanish residents and $107 more than
their counterparts in France.
However, for some products Britons are offered lower prices so the proposal will also benefit other Europeans.
For example, some products bought online from IKEA are cheaper.
Amazon, the online bookshop, favours British residents with prices consistently lower than in France and
Germany for the same products.
Britain has long had a reputation as one of the most expensive countries in Europe and has been called
Treasure Island by multinational firms.
It had been hoped that the European single market and the internet would put pressure on prices to fall.
However, studies have found British consumers are consistently charged more than those on the Continent.
In countries that have adopted the euro, prices have converged, although not as quickly as was hoped. Over the
past two years, studies have found that price convergence has all but stopped as companies try to maintain their
profit margins.
A spokesman for British Airways said: All the other airlines do it. All the airlines offer reduced fares to attract
customers outside their market.
A Hertz spokesman said: For decades, the market where goods and services are purchased has been a pricing
factor in the travel industry. Costs and competitive conditions in individual markets are among the considerations
that affect pricing. Thomas Cook said its British and French arms act independently. Sony declined to comment.
'Mercedes-Benz, has accepted that radical changes in the world car market mean that Mercedes-Benz will no
longer be able to demand premium prices for its products based on an image of effortless superiority and a
content of the ultimate in automotive engineering.
Instead of developing the ultimate car and then charging a correspondingly sky-high price as in the past,
Mercedes-Benz is taking the dramatic and radical step of moving to 'target pricing'. It will decide what the
customer is willing to pay in a particular product category priced against its competitors it will add its profit
margin and then the real work will begin to cost every part and component to bring in the vehicle at the target
price.
'The marketing motto for the Mercedes-Benz compact C-class is that it offers customers more car for their
money.
It is the first practical example of the group's new pricing policy. The range embodies a principle new to
Mercedes which states that before any work starts a new product will be priced according to what the market will
bear and what the company considers an acceptable profit. Then each component and manufacturing process
will be costed to ensure the final product is delivered at the target price.
137
CHECKPOINT 2
Under the old system of building the car, adding up the costs and then fixing a price, the C-class would have
been between 15 per cent and 20 per cent dearer than the 10-year-old outgoing 190 series, Mr Vhringer said.
Explaining the practical workings of the new system, he explained that project groups for each component and
construction process were instructed without exception to increase productivity by between 15 and 25 per cent.
And they had to reach their targets in record time.
One result was that development time on the new models was cut to 40 months, about a third less than usual.
But the most important effect, according to Mr Vhringer, has been to reduce the company's cost disadvantages
vis--vis Japanese competitors in this class from 35 per cent to only 15 per cent.'
The Metropolitan Police spent $122m in a year on writing letters and general paperwork, latest figures have
shown.
The cost - which does not include admin duties related to specific crimes and incidents - was up 13% on 2004-5.
It easily exceeded the combined sum the country's biggest police force spent on tackling domestic burglaries
($48.75m) and sexual offences ($55.28m).
The Met spokesman said the figure had risen because of improvements in collection and collation of data.
Details of the force's spending were disclosed in preliminary Activity Based Costing (ABC) information due to
be presented to the Metropolitan Police Authority on Thursday.
The category for "non-incident Linked Paperwork" - including general correspondence not related to any specific
incident took up 3.8% of the Met's total resources.
Only five other activities left the force with a bigger bill. Top was "National, international and capital city policing,
including anti-terrorism and Special Branch" ($505m), "visible patrols" came second at $313m and tackling
"violence against the person" cost $176m.
All police forces have to collect ABC data, which assesses not only the direct cost of activities but other
financial implications such as officers' time and running support departments.
A Met police spokesman said: "The Met is the largest single employer in London and this category reflects the
operational feat involved in running an organisation on that scale.
"It covers all the paperwork required to keep the service functioning - from ordering uniform and officer's pocket
books, to leave applications, search forms and quick statements.
"The MPS has a unit that is seeking to eliminate unnecessary paperwork. Part of this work is to use skilled police
staff to process paperwork to free up officers to spend more time on their operational duties."
138
Overview:
Part 2
Cost analysis
Activity-based management
Customer profitability
analysis
Distribution channel
profitability
Pareto analysis
139
Direct product
profitability
8: COST ANALYSIS
1.1
1.2
ABM
DPP
Cost
Reduction
Cost
Modelling
Key
products
CPA
Key
customers
Key activities
1.3
ABM moves away from ABC as a product costing device and uses the information
generated to control or reduce cost drivers and reduce overheads, thus gaining competitive
advantage.
140
8: COST ANALYSIS
2.1
Customer profitability analysis (CPA) is 'the analysis of revenue streams and service costs
associated with specific customers or customer groups'.
(CIMA Official Terminology)
2.2
CPA uses ABC principles to identify the most profitable customers or groups of customers
so that marketing efforts can be directed towards attracting and retaining these customers.
X
X
X
(X)
$X
$'000
X
(X)
X
(X)
X
Cost Driver
Order processing
Delivery
Number of visits
141
8: COST ANALYSIS
Section 6
Distribution
Channel
Profitability
3.1
ABC information can also be used to determine the profitability of different distribution
channels.
3.2
Distribution channels are the means a company transacts with its customer. They can be
direct or indirect.
Direct channels include, shops, sales teams, internet whereas indirect channels include
retailers, wholesalers etc
3.3
Traditionally, product costs are allocated to distribution channels based on standard costs
and the product mix sold through the channel.
Sales, general and administrative costs are typically allocated to distribution channels on the
basis of sales volume or net revenue.
3.4
However, different channels will use some activities but not all. ABC information allows an
understanding of different channel profitability by creating cost pools for activities.
3.5
142
8: COST ANALYSIS
4.1
DPP is the contribution a product category makes to fixed costs and profit. It is
calculated as follows:
Sales price
Less: purchase cost
Gross margin
Less: direct product costs
warehouse direct costs
transport direct costs
store direct costs
Direct product profit
4.3
(X)
(X)
(X)
$
X
(X)
X
(X)
(X)
Any costs that are general to the organisation, but not specific to any one product, should
be ignored in calculating DPP.
Supermarkets analyse the direct profitability of every branded and non-branded product they
sell. This helps them to decide on what ranges to present in store and also provides a focus
for marketing initiatives.
143
8: COST ANALYSIS
Lecture example 2
A supermarket is considering the profitability of two different brands and types of washing
detergent. SoapySuds is a compact tablet form of detergent; WhiteyWhite is conventional soap
powder.
The following information relates to each product:
Cost price per unit
Required margin on sales
Shelf space occupied per product unit
Average time in warehouse
Average time in store
Monthly unit sales per supermarket branch
Normal order batch size (units)
SoapySuds
$3.40
15%
0.008m3
8 weeks
3 weeks
1,200
2,000
WhiteyWhite
$2.40
20%
0.022m3
6 weeks
3 weeks
1,800
2,250
Cost associated with placing orders are $150 irrespective of order type or size.
Goods are transferred from the warehouse to the supermarket branches in trucks with a capacity
of 100m3. The average journey costs $120.
Warehousing costs total $480,000 per month and the warehouse manager estimates that 60% of
its capacity of 800,000m3 is utilised.
Each supermarket branch has storage costs of $250,000 per month and has 200,000m3 of shelf
space.
General administration costs are $175,000 per month.
Required
Calculate the profit per item using the direct product profitability method.
Solution
144
8: COST ANALYSIS
Q8 KL
145
8: COST ANALYSIS
Pareto analysis
5.1
Pareto analysis is used to highlight the general principle that 80% of value is concentrated in
only 20% of a population.
For example
5.2
Pareto analysis may not apply precisely. The basic principle is that a small amount of the
population often accounts for a high proportion of value.
5.3
5.4
5.5
This analysis may be beneficial for non-accounts staff such as sales or marketing.
Lecture example 3
Introductory example
The following Pareto curve has been produced for the customers of Company L.
Total
customer
margin
$'000
100
80
20
50
100
Number of customers
Required
Analyse the above graph and suggest how the company could improve its position.
Solution
146
8: COST ANALYSIS
147
8: COST ANALYSIS
Chapter summary
Section
Topic
Summary
Traditional
absorption
costing
Activity-based
costing
Cost driver
analysis
Unit
Batch
Product
Facility sustaining.
Activity-based
management
5, 6 & 7
Customer
profitability
analysis
Distribution
channel
profitability
Direct product
profitability
Pareto analysis
END OF CHAPTER
148
9a
Cost management
techniques 1
Identification of appropriate
quality cost categories for
various items and calculate the
spend in each may be required.
149
Overview
World class
manufacturing
Continuous
Improvement
TQM
Just-in-time
Kaizen Costing
150
Business process
re-engineering
Throughput accounting
and the theory of
constraints
1.1
Focus is on:
(a)
(b)
(c)
(d)
(e)
(f)
1.2
Quality
Reliability
Customisation
Innovation
Flexibility
JIT based production
Main benefits:
(a)
(b)
(c)
(d)
(e)
(f)
2.1
2.2
Continuous improvement
Never be satisfied with current achievement. It is always possible to improve
performance.
2.3
Innovation
Eliminate waste
Everybodys concern
Teamwork
Establishing standards
Establishing procedures to deliver the quality standards
Monitoring actual quality
Taking control action when standards are not achieved
151
Design quality into an organisation's products and operations from the outset.
(a)
(b)
(c)
2.5
Costs of quality
Prevention costs
Costs of conformance
Appraisal costs
Internal failure costs
Costs of non-conformance
It is generally accepted that there is a trade off between expenditure in these two categories.
The greater the spend on conformance costs, the lower the resulting non-conformance
should be.
2.7
Most organisations accept that some failures will occur, thus incurring non-conformance
costs, but they will seek to minimise these costs by incurring quality conformance costs.
Lecture example 1
Preparation question
Required
Allocate the following costs into appropriate categories of quality costs and prepare a 'cost of
quality' report. Comment on your findings.
20X6
$'000
40
125
35
50
85
60
395
Solution
152
20X7
$'000
120
60
15
20
70
20
305
Performance measurement
2.8
2.9
153
Lecture example 2
Preparation question
Required
Identify some of the possible impacts of TQM on efficiency, inventory and cost
Solution
Efficiency:
Inventory:
Cost:
Q9 Total quality
Management
Kanban
2.11 Kanban control systems control the flow of goods through a manufacturing process. They
are the only means of authorising production it is pulled through the system by demand.
2.12 Kanban can only work if defects are eliminated.
2.13 Kanban also permits idle time and allows labour to be used where it is most needed.
154
Continuous improvement
3.1
3.2
Kaizen costing
4.1
Kaizen costing focuses on obtaining small, incremental cost reductions during the
production stage of the product life cycle.
4.2
4.3
Value analysis
Functional analysis
Analysis
Cost set
Design
Functional
Target
Value
Continuous improvement
Kaizen costing
Actual = base
New standard set
New base cost
New standard cost
Standard v Kaizen
4.4
Concepts
Techniques
Employees
Standard
Kaizen
Cost control
Cost reduction
Unchanged manufacturing
conditions
Continuous improvement
Meet standards
Variance analysis
Investigate variances
Cause of variances
Source of solutions
155
Just-in-time
5.1
JIT is a system whose objective is to produce or buy units as they are required rather than
for inventory. It is a demand 'pull' system.
5.2
JIT aims to restructure the manufacturing process to bring about more flexible, rapid and
cost effective production. This will include the elimination of non-value adding activities.
5.3
JIT philosophy is to investigate failures, since the failure is an opportunity to improve the
process. The problem might be due to machine failure, a set-up or quality problem etc.
5.4
5.5
JIT Purchasing
JIT Production
Lower inventory
Frequent deliveries
Produce to order
Zero defects
Quality assurance
Flexible workforce
Continuous improvement
Quality control
156
Lecture example 3
Preparation question
Required
Identify some of the possible impacts of JIT on efficiency, inventory and cost
Solution
Efficiency:
Inventory:
Cost:
157
The theory of constraints is a production system where the key financial concept is the
maximisation of throughput while keeping conversion and investment costs to a minimum.
6.2
6.3
Bottlenecks
6.4
Raw
Materials
Materials
Preparation
Component
Preparation
Final
Assembly
100 units
per hour
50 units
per hour
100 units
per hour
Sales
158
Key resources
6.6
In practice the key resource in a factory may not be machine time or labour hours. Any
constraint that reduces production flow can be used when calculating return or cost.
Lecture example 4
Preparation question
Machine type 1
Machine type 2
Product Y
Hours per
unit
4.5
2.5
Product C
Hours per
unit
3.0
2.0
The capacity of the machine type 1 is 600 hours and machine 2 is 500 hours per month.
Maximum monthly demand (units)
120
70
60
Required
Calculate the machine utilisation rate for each machine each month and explain which of the
machines is the bottleneck/limiting factor
Solution
159
6.8
Traditional costing
Throughput accounting
Lecture example 5
Preparation question
Required
Identify some of the possible impacts of the Theory of Constraints on efficiency, inventory and
cost
Solution
Efficiency:
Inventory:
160
Ratios
6.9
(a)
(b)
(c)
TA ratio =
Ranking production
6.10 Products or divisions are ranked by TA ratio.
6.11 If two or more products are made in the same factory, they can be ranked on return per
factory hour, not TA ratio, since their costs will be identical.
161
Lecture example 6
BR is preparing its production plan for the next three months and has estimated the maximum
demand from customers as follows:
Product
A
B
C
Units
200
100
75
Selling price
Material
N ($8/kg)
O ($12/kg)
P ($9/kg)
Labour ($8/hour)
Fixed Overheads
16
12
27
28
17.50
B
$/unit
230
8
27
45
57
35.62
C
$/unit
280
24
24
90
32
20
BR guarantees its workers a weekly salary equivalent to their normal working hours at an hourly
rate of $8/hour.
BR has recently been informed by a supplier that there is a worldwide shortage of material P. As a
result, the supplier will only be able to supply 1,000 kgs over the next three months.
Required
Solution
162
163
Section 10
Business process
re-engineering
7.1
One method to reduce non-value added costs and activities is business process reengineering.
7.2
BPR is the fundamental rethinking and radical design of business processes to achieve
dramatic improvements.
Fundamental
7.3
BPR begins with no regard for a companys current operations: it asks what a company
must do, and then how to do it.
Dramatic
7.4
BPR is not about making incremental performance improvements, these can be achieved
using current techniques like TQM.
Processes
7.5
Most business are task oriented rather than process oriented, where a process is defined as
a collection of activities that adds value to a customer. The shift to process-based thinking
is critical.
164
Chapter summary
Section
Topic
Summary
World class
manufacturing
Total quality
management
Continuous
improvement
Kaizen costing
Just in time
Throughput
accounting
Business
process reengineering
165
END OF CHAPTER
166
9b
Cost management
techniques 2
An explanation of the
components of the extended
value chain has been examined
with application to the scenario
given.
167
Overview
Supply chain
management
Outsourcing
Value chain
Partnering
Incentives
Gain sharing
168
1.1
Michael Porter observed that an organisation is essentially a system that converts inputs
into outputs, the aim being to add value to the customer which they will find attractive and
be willing to pay for and therefore make profits.
A firm is profitable if:
Value perceived by customers > Cost of activities that create that perception.
Example a restaurant
1.2
BUYING
COOKING
SERVING
A restaurant's activities can be divided into buying food, cooking it, and serving it. The
ultimate value a firm creates is measured by the amount customers are willing to pay for its
products or services above the cost of carrying out value activities.
Lecture example 1
Brainstorming question
What is it that customers value that enables an average spend of 2.99 at McDonalds compared
with 200 in a Michelin star restaurant?
Solution
BUYING
COOKING
169
SERVING
Porter analysed the various activities of an organisation into a value chain. This is a model
of value and activities and the relationship between them and is particularly useful in a
manufacturing environment.
SUPPORT ACTIVITIES
Firm infrastructure
Human resource management
Technology Development
Procurement
Inbound
logistics
1.4
Marketing
and Sales
Outbound
Logistics
Service
Porters value chain is a graphical representation of what a firm does to add value. It
illustrates the:
(a)
(b)
(c)
1.5
Operations
Support activities
(a)
(b)
(c)
(d)
1.6
Design
Production
170
Marketing
Distribution
Customer
service
The value chain asserts that whilst excellence in manufacturing is essential for success it is
not sufficient to guarantee success.
All business factors should still add value and can run consecutively and concurrently. Value
can also be added by the way in which these activities are linked.
(a)
(b)
(c)
(d)
(e)
(f)
A company's value chain is not bounded by a company's borders, its connected to what
Porter describes as a value system.
1.9
As well as managing its own value chain, a firm can secure competitive advantage by
managing the linkages (ie relationships) with the value chains of its suppliers and
customers.
1.10 For example, our inbound logistics needs to coordinate well with the outbound logistics
and operations planning of suppliers.
1.11 A firm's value chain is not always easy to identify nor are the linkages between the different
elements. However, it is an important analytical tool because it helps:
(a)
(b)
(c)
(d)
171
Prime airports
Prime slots
New seats
Aircraft
layout
Quality
food
Multiple
booking
methods
Checkin/out
systems
Lecture example 2
Lost
luggage
return
Brainstorming question
Suggest appropriate ways for a 'no frills' carrier such as EasyJet to add value.
Solution
R+D
Design
Business
passengers
Production
172
Marketing
Distribution
Customer
service
A belief in quality
Our reputation has been built, above all, on the quality and freshness of our food. It is what our
customers want, and it is what gives us our edge over other supermarkets:
We are committed to bringing you the best quality food. Should you not enjoy one of our products,
tell us and well replace and refund you.
Of vital importance to us is the provenance and traceability of the food that is on our shelves. Each
of our buyers is an expert in his or her own field. Much of their time is spent with the farmers,
growers and suppliers, building relationships based on trust and respect. Wherever possible our
buyers buy British. Increasingly, they are also sourcing local produce from small growers and
suppliers close to individual Waitrose stores.
Although we always seek a good deal for our customers, we also expect to offer producers a fair
return and develop supportive, long-term relationships with them. This means we can help
producers in poorer countries invest for the future, as well as being sure they operate to high
ethical standards. Waitrose was the first supermarket to sell loose Fairtrade bananas, thanks to
our partnership with a group of 100 small growers on the Windward Islands. We guarantee them a
year-round fair price, and regularly send our buyers and agronomy specialists to the Islands to
offer advice and help with anything from fertilisers to packaging. All bananas sold at Waitrose are
now Fairtrade.
Waitrose Entertaining
Waitrose Entertaining can help you cater for any event, from home entertaining for a few friends to
special occasions such as a wedding reception for hundreds. With menu ideas including oven
ready dishes, canaps, celebration cakes, and fruit baskets, Waitrose Entertaining will bring
something special to any occasion you may be planning.
Quick Check
Quick Check is our scan as you shop service. Using a handheld scanner, you scan each item as
you take it from the shelves and pack as you go. When you have finished shopping, all that is left
to do is pay at the Quick Check till, without having to unpack and re-pack your shopping. If paying
using a debit, credit or account card you can save even more time by using Quick Pay. Quick
Check is available in a number of branches. We will also supply special reusable bags to our
partnership cardholders and Waitrose and John Lewis account card cardholders.
Home delivery
At selected branches you can choose to have your shopping delivered to your home. If you pay
with your partnership card or with your Waitrose or John Lewis account card you can take
advantage of our Fast track service. On completing your shopping take your goods to the Delivery
Service Desk or Fast track collection point and we'll do the rest for you - there's no need for you to
go through the checkout.
173
Branch extras
We can lend you wine and beer glasses, and even fish kettles, free of charge. You will only pay for
any breakages.
174
Foundation
The Waitrose Foundation is a partnership created in 2005 to help improve the lives of the farm
workers who grow and pick our South African fruits. Money raised by the sale of Waitrose
Foundation fruit is spent on projects that are chosen by and directly benefit the farm workers.
Instead of funding through a price premium, Waitrose - in conjunction with growers, importers and
exporters pass a percentage of profits into a trust to pay for educational, social and healthcare
projects chosen by workers committees. So far, there are 93 projects and more than 20,000 farm
workers and their families have benefitted from the work funded by the Foundation.
Fair trade
The Fairtrade Foundation is the only independent certifier of ethically-traded products in the UK,
guaranteeing producers receive a fair price for their goods whatever the market conditions.
Companies have also set up fair-trading schemes. In our coffee section, you'll see products
certified by the Rainforest Alliance, which aims to provide fair wages and decent conditions for
workers and encourage environmentally friendly farming practices; Good African Coffee, which
shares profits fifty-fifty with growers; and Utz Kapeh, which empowers producers by teaching them
professional growing and marketing techniques, treats workers fairly and meets specified
environmental standards.
175
Lecture example 3
The value an organisation creates is measured by the amount customers are willing to pay for its
products and services less the cost of providing those products and services
Required
Explain how an understanding of the Value Chain and what drives value for a customer, could be
used in Waitrose.
Solution
176
2.1
A supply chain can be defined as the entities required to supply products to customers.
Typically this will include: manufacturers, suppliers, distribution centres and retail outlets.
The activities involved in the supply chain can be equated to the primary activities in Porters
Value Chain.
2.2
Supply chain management is the co-ordination of all supply activities of a company from it
suppliers to its customers.
2.3
Section 2
Supply Chain
Management
(a)
(b)
Supply chain management challenges this approach. It suggests that members of the
supply chain should collaborate to produce something of value for the end customer. Coordinating the activities of the different businesses on the supply chain saves costs while
also adding value and synergies are achieved that benefit every member in the chain.
(a)
Consolidating the supplier base few suppliers with long term relationships
(b)
(c)
(d)
Advantages
2.6
(a)
(b)
(c)
(d)
(e)
(f)
(g)
177
Lecture example 4
Brainstorming question
Required
Suggest ways in which supply chain management can provide these advantages.
Solution
Lecture example 5
Idea generation
Required
Using the Waitrose Case study earlier in this chapter detail the ways in which Waitrose manages
its supply chain.
Solution
178
Outsourcing
3.1
3.2
It has been suggested that, in the next 10 to 20 years, most organisations will have
outsourced every part of the value chain except the few key components that provide
competitive advantage.
3.3
Advantages
Disadvantages
superior quality
efficiency
economy of scale
capacity
flexibility
Ethical considerations
Employee opposition
Lecture example 6
Brainstorming question
Required
What are the specific advantages and disadvantages of outsourcing customer services to
developing economies?
Solution
179
4.1
Partnering
Unlikely partners
offer best of all
worlds
4.2
4.3
4.4
Section 4.1
Partnering
(b)
4.5
Strategic partnering (longer-term partnering for agreements involving more than one
project)
Project specific partnering.
Partnering involves:
(a) Agreeing mutual objectives
(b) Devising ways to resolve disputes
(c) Continuous improvement
(d) Measuring progress
(e) Sharing gains
180
Components
Suitability
Cost savings
Trust
Profit rises
Shared procedures
Rapid expansion of
construction
Reduced times
Team working
Time critical
Lower risk
Repetitive projects
Improved quality
Mutual interdependence
Expertise required
Improved safety
Higher customer
satisfaction
Lecture example 7
Brainstorming question
Solution
181
Incentives
4.7
4.8
Incentives encourage partners to work together to provide benefits to the client beyond
those stipulated by contract.
Examples of performance that could be considered for incentives:
Cost
Time
Quality
Safety
Gain sharing
4.10 The concept of gain sharing is not new. Bonuses based on company profits or share
options for employees have been in existence for a long while. However, gain sharing is not
limited to gains within an organisation, but also incorporates contracts between separate
companies.
4.11 Both parties agree to share any benefits that are achieved over and above those specified in
the contract
4.12 Gain sharing arrangements could also be pain/gain sharing. All cost overruns or cost
savings are shared between customer and contractor. This can be extended to the entire
supply chain.
4.13 Gain sharing can cause
(a)
(b)
(c)
(d)
These gains will need to be assessed financially through open book accounting.
182
Chapter summary
Section
Topic
Value chain
Summary
The value chain is an attempt to show the activities
performed by an organisation to add value, that is to make
profit, and to satisfy customers.
The extended value chain includes both suppliers and
customers.
Supply chain
management
Outsourcing
Partnering,
incentives and
gain sharing
183
END OF CHAPTER
184
10
Budgeting
185
10: BUDGETING
Overview
Responsibility
accounting
Budgetary control
Budgeting
186
Beyond budgeting
Behavioural aspects
of budgeting
10: BUDGETING
Introduction
1.1
2.1
Budgeting is part of the overall process of planning and control. A budget is a plan which will
assist in achieving objectives.
2.2
Control
Compare actual with budget
Planning
Set budget
Operate in line
with objectives
Budgetary control
3.1
Systems theory
A system must be controlled to keep it steady or enable it to change safely.
Control is required because unpredictable disturbances arise and enter the system, so that
actual results/(outputs) deviate from expected results.
Examples of disturbances from the environment which would impact on a business system
would be as follows:
A control system must ensure that the business is capable of surviving the disturbances.
187
10: BUDGETING
3.2
(b)
(c)
(d)
The means to initiate control action (effector) (eg the purchasing manager who may
source cheaper materials based on an adverse variance report)
This flow of information through a system is known as the feedback loop and is
represented diagrammatically below:
Effector
Comparator
Standard
Sensor
Input
3.3
Process
Output
The feedback loop shown above is effectively a single feedback loop in that it is confined
to information coming from within the organisation and refers to a fixed budget. This can be
compared to a double feedback loop, in which the external environment is monitored and
action maybe taken to modify the control system itself (for example, the budget may be
amended to reflect an expected global increase in a material cost, or new product lines may
be introduced).
Feedback control
3.4
188
10: BUDGETING
Feedforward control
3.5
Forecast
Current date
Fixed budgets
4.1
The fixed budget is the master budget prepared before the beginning of the budget period.
It is based on budgeted volumes and costs/revenues and is not adjusted regardless of the
level of activity attained in the period.
Flexible budgets
4.2
The flexible budget is a budget which is designed to change as volume of activity changes.
This can be done by recognising the behaviour of different costs (fixed or variable).
Flexible budgets have two uses:
(a)
(b)
Retrospectively, at the end of a control period, to compare actual results with what
should have been achieved. This is essential in budgetary control.
(a)
Designed to cope with different activity levels to keep the budget meaningful and
hence preserve the relevance of variances for effective control.
(b)
Useful at planning stage to show different results from possible activity levels.
(c)
10: BUDGETING
Rolling budgets
4.4
Rolling budgets are also called continuous budgets. They are particularly useful when an
organisation is facing a period of uncertainty making it difficult to prepare accurate
forecasts.
4.5
Rolling budgets are an attempt to prepare targets and plans which are more realistic and
certain, particularly with a regard to price levels, by shortening the period between
preparing budgets.
4.6
Instead of preparing a periodic budget annually for the full budget period, budgets would be
prepared, say, every one, two or three months (four, six, or even twelve budgets each year).
Each of these budgets would plan for the next twelve months so that the current budget is
extended by an extra period as the current period ends: hence the name rolling budgets.
Cash budgets are usually prepared on a rolling basis.
(a)
(b)
(c)
(d)
(a)
(b)
Flexed budgets
5.1
The use of flexible budgets in budgetary control can be referred to as ascertaining the
budget cost allowance, or flexed budget. A flexed budget or budget cost allowance is a
budget that has been prepared based on actual volumes for budgetary control purposes. It
is a more meaningful performance evaluation tool as it allows a like for like comparison
to be made.
The flexed budget forms the basis for standard variance analysis (ie actual activity should
have cost)
190
10: BUDGETING
Lecture example 1
Chateau Larnaque has a bottling plant for its wine and has prepared flexible budgets:
Flexible Budgets
Bottles:
Production costs:
Materials
Labour
Overhead
10,000
$
30,000
27,000
20,000
12,000
$
36,000
31,000
20,000
14,000
$
42,000
35,000
20,000
Required
Calculate meaningful variances for performance evaluation purposes, if actual production was
12,350 bottles and the production costs were:
Materials
Labour
Overhead
Total
35,000
32,000
23,000
90,000
Solution
191
10: BUDGETING
Responsibility accounting
Responsibility accounting
6.2
6.3
Responsibility
structure
Manager's area of
responsibility
Typical financial
performance measure
Cost centre
Revenue centre
Revenues only
Revenues
Profit centre
Controllable profit
Investment centre
Responsibility accounting associates costs and revenues with the managers that can
control them. It therefore distinguishes between controllable and uncontrollable costs.
General considerations
7.1
Accountants must consider the impact of their budgeting systems on human behaviour.
(a)
(b)
(c)
(d)
A good system of control must influence employees in the direction of the companys best
interests.
The level at which standards and budgets are set will affect employee motivation and
therefore their behaviour.
(a)
(b)
Attainable standard makes an allowance for normal inefficiencies but also includes
hoped-for improvements.
192
10: BUDGETING
(c)
(d)
7.3
7.4
It is vital that the goals of management are in line with the goals of the organisation as a
whole. This is known as goal congruence.
7.5
A manager who is assessed by his ability to meet budget may not undertake activities if they
are not in the budget or be cautious about taking new business opportunities. Budgetary
control should not be so rigid that it constrains the business.
7.6
Management accountants should therefore try to ensure that management and employees
have positive attitudes towards setting and implementing budgets, and feedback of results.
Participation in budgeting
7.7
(a)
(b)
(c)
(d)
Likely to be quicker
Avoid budgetary slack and budget bias
Utilise senior management awareness of total resource availability
Avoids taking local management away from day-to-day duties
(a)
(b)
(c)
193
10: BUDGETING
Lecture example 2
Required
Briefly outline the advantages and disadvantages of allowing profit centre managers to participate
actively in the setting of the budget for their units.
Solution
Beyond budgeting
8.1
In recent years the following criticisms have been levelled at the traditional budgeting
process that is traditional budgets:
(a)
(b)
(c)
(d)
(e)
Are time consuming to produce and add little value to the business
Have insufficient external focus
Are too rigid and prevent fast response
Protect rather than reduce cost
Stifle innovation
Since the late 1990s some companies have shifted their focus from the traditional budgetary
cycle in favour of 'beyond budgeting'. Examples include Volvo, Ikea and Bulmers.
194
10: BUDGETING
8.2
(b)
(c)
Lecture example 3
Orchard designs and sells mobile phones. Traditionally they have prepared detailed budgets each
year. The MD is now considering changing its budgeting approach to a 'Beyond Budgeting'
approach.
Required
Advise the management whether a beyond budgeting approach should be adopted.
Solution
195
10: BUDGETING
Chapter summary
Section
Q10 M plc
Topic
Summary
Introduction to
budgeting
Budgetary control
Responsibility
accounting
Behavioural aspects of
budgeting
Beyond budgeting
END OF CHAPTER
196
CHECKPOINT 3
Take some time to reflect on the knowledge and skills you covered during Stage 3. If you feel you need further
clarification on any of the key areas listed below you can use the on-line lecture for the relevant chapter. The
Course Notes section for each chapter (starting overleaf) provides helpful guidance (and time commitments) on
how to focus your review on the key learning points in your notes.
Key knowledge
Many of the other topics covered in this stage you may have seen before either at P1 or E1 (P4 under the old
syllabus).
It is important not to neglect these areas though as they may well be examined in a different manner at P2 to that
in the other papers. For example, throughput accounting may not be examined purely via calculation but may
include a discussion of for example, its impact on stock valuation compared to traditional accounting.
Activity Based Costing
ABC whilst examined in a very similar manner to P1 will probably have more discussion marks and may
incorporate techniques such as CPA / DPP / Pareto analysis.
Cost management techniques
As mentioned already, these techniques whilst having been seen before will be examined very often via a greater
discussion than seen previously.
The techniques in chapter 9b are normally examined via an explanation of the concept before then having to
apply your knowledge to a given scenario.
Budgeting
You will have already seen aspects of budgeting in P1. P2 will examine different aspects of budgeting focussing
on discussions around controllability and behavioural implications of budgeting as well as evaluating
performance through flexed budgets.
Key skills
The exam will require concise written answers to questions on topics like budgeting. From stage 3 you should
recognise that the ability to explain or discuss key techniques is an important exam skill.
At Management Level, you are expected to do more than the basics as well as knowing the definitions of the
key concepts you also need to be able to clearly explain these concepts, and discuss when they should be used
or how they apply to various situations you may be given.
197
CHECKPOINT 3
70 mins
Key areas - use the online lectures to selectively review these if you need to
Course Notes
Review sections 5 & 7 to ensure you understand how ABC can be applied to customers and
retailers.
10 mins
Question Practice
Attempt Question 8 from the Question and Answer Bank in the back of the course notes.
Ensure that you are comfortable with the discussion required in part (d) as the interpretation of
calculations is very important for P2.
45 mins
Additional Resources
Study Text
Review section 3.8 & 3.9 which looks at evaluating performance and implementing ABM.
Further information on distribution channel profitability can be found in section 6. Review this if
time permits.
10 mins
5 mins
80 mins
Key areas - use the online lectures to selectively review these if you need to
JIT & TQM
Throughput accounting
Course Notes
Review these techniques to ensure that you can talk about their impacts on efficiency,
inventory and cost.
Work through lecture example 6 again to ensure you are comfortable with the throughput
accounting ratios.
Question Practice
Attempt Question 9 from the Question and Answer Bank in the back of the course notes. It is
important that you get into the habit of planning your answers for written questions before
starting to answer these questions and that you take note of the format required ie report
format.
Additional Resources
Brought forward knowledge
EOQ this and the formulae for the holding cost of stock etc are still examinable in the P2
syllabus and could be examined via a comparison with JIT. An online lecture is available to
cover this.
Study Text
Take brief notes on section 10 on business process re-engineering.
If there are areas in this chapter that your memory is hazy on, review the relevant section in
the text. (would take approx 10 mins)
Real-life examples
An article looking at testimonies of businesses who have used TQM is contained at the end of
the checkpoint. (If you have time, take a couple of minutes to review this)
198
10 mins
15 mins
20 mins
30 mins
5 mins
CHECKPOINT 3
20 mins
Key areas - use the online lectures to selectively review these if you need to
Value chain
Outsourcing
Course Notes
Review the chapter particularly for the areas that you havent covered elsewhere in your
studies to date.
Additional Resources
Study Text
Review the additional detail in section 2 on supply chain management
Review section 4 partnering, and ensure you can explain the key features of it.
10 mins
5 mins
5 mins
Real-life examples
Review the articles at the end of this checkpoint on supply chain management and partnering
to add to your understanding of how these techniques are used. (this should take 5 10 mins)
75 mins
Key areas - use the online lectures to selectively review these if you need to
Budgetary control
Budgets for planning and control
Behavioural aspects of budgeting
Course Notes
Review this chapter and ensure you can explain the various techniques including when they
are suitable, their benefits and drawbacks.
10 mins
Question Practice
Attempt Question 10 from the Question and Answer Bank in the back of the course notes.
This question involves both calculations and discussion. Practice, especially of the written
elements is important preparation for the exam.
60 mins
Additional Resources
Study Text
Ensure you are familiar with section 5 which looks at using spreadsheets to build business
models.
5 mins
199
CHECKPOINT 3
A company makes product X which passes through three production operations A, B and C.
Product X sells for $8 per unit and has a direct materials cost of $3 per unit.
Total labour cost for the period is $10,000 and overheads for the same period amount to $14,000.
Processing times per unit and maximum processing times available for the three operations are given
below:
Operations
A
3 mins
30,000
B
11 mins
50,000
C
6 mins
80,000
(2 marks)
What are the primary activities of Porter's value chain for a manufacturing company?
A
B
C
D
0.32
0.45
0.48
0.94
A
B
C
D
(2 marks)
200
CHECKPOINT 3
Increased value
Cheaper prices from suppliers
Higher waste
Collaboration of members
Higher quality
A
B
C
D
Gain sharing is
A
B
C
D
(2 marks)
(2 marks)
A
B
C
D
(i) only
(i), (ii), and (iii)
(i), (iii) and (iv)
(i) and (iv)
(2 marks)
ABC plc uses an activity based costing to allocate overheads to its products.
Product
Production units
Batch size
A
15,000
2,500
B
25,000
5,000
C
20,000
4,000
Machine set up costs are driven by the number of batches of each product and have been estimated to
be $300,000 for the year.
Calculate the machine set up costs that would be allocate to each unit of product C.
(3 marks)
Revenue
$'000
500
700
2,500
1,600
1,800
7,100
201
Profit
$'000
410
340
740
390
720
2,600
CHECKPOINT 3
(3 marks)
(3 marks)
10
B
20
C
50
Number of customers
What possible decisions would it be useful for K plc to take for customers in groups A, B and C?
(3 marks)
11
GK manufactures two products in its factory in Italy, the Romeo and the Romolo. Both products require
the use of a machine in the factory, which has broken down on numerous occasions in recent months. It
is currently operational for approximately 6,800 hours per annum. GKs management intends to replace
the machine next year, but until then seeks advice as to which product to manufacture.
Information about the products is as follows.
Romeo
Romolo
$120
$160
$50
$90
$35
$25
0.65 hour
0.75 hour
Maximum demand
10,000
8,000
Using a throughput accounting approach, recommend which product GK should choose to manufacture
first.
(2 marks)
12
Flexed budgets for the cost of hotel laundry based on occupancy percentages are shown below.
Occupancy
82%
94%
Laundry cost
$410,000
$429,200
During the period, the actual occupancy was 87% and the total laundry cost was $430,000.
The variance on laundry was:
A
$5,000 adverse
$12,000 adverse
$5,000 favourable
$12,000 favourable
(2 marks)
202
CHECKPOINT 3
Explain, giving examples, how budgets can be used for feedback control and feed-forward control.
(5 marks)
Define budgetary slack and describe TWO negative consequences of budgetary slack for an
organisation.
203
(5 marks)
(5 marks)
CHECKPOINT 3
Throughput ratio
8-3
11
0.45/minute
24,000
50,000
0.48/minute
0.45
0.48
0.94
location based
highly accurate
allocation focused
linkages
cost reduction
are important
4
There should be lower waste as quality is improved. Purchase prices might increase, but other
costs will be reduced.
Benefits may be financial eg cost savings but may also occur in terms of quality, timing or
specification. Gain sharing encourages partnership to increase value and improve performance.
7
Product
Production units
Batch size
No of batches
Machine set up costs
A
15,000
2,500
6
B
25,000
5,000
5
$300,000
204
C
20,000
4,000
5
Total
16
CHECKPOINT 3
8
Product
Revenue
$'000
2,500
1,800
1,600
700
500
X
Z
Y
W
V
Cumulative Revenue
$'000
2,500
4,300
5,900
6,600
7,100
%
35.2
60.6
83.1
93.0
100
Profit
$'000
740
720
410
390
340
2,600
X
Z
V
Y
W
Cumulative Profit
$'000
740
1,460
1,870
2,260
2,600
%
28.5
56.2
71.9
86.9
100
Group B
Group C
11
Throughput per unit
Romeo
Romolo
($(160 90))=$70
0.65 hr
0.75 hr
$108
$93
1st
2nd
B
Use the high/low method:
Occupancy
Highest activity level
Lowest activity level
Variable cost per occupancy% = 19,200 / 12 = 1,600
Total cost for 82%
Variable cost for 82% = 82 x $1,600 =
Fixed cost
94%
82%
12%
410,000
(131,200)
278,800
278,800
139,200
418,000
205
Cost
429,200
410,000
19,200
CHECKPOINT 3
Variance:
418,000
(430,000)
12,000 (A)
Section B
1
Step 2
Exploit the highest possible output must be achieved from the binding constraint. This
output must never be delayed and as such a buffer inventory should be held immediately
before the constraint
Step 3
Subordinate. Operations prior to the binding constraint should operate at the same speed
as it so that WIP does not build up
Step 4
Elevate the systems bottleneck. Steps should be taken to increase resources or improve
its efficiency
Step 5
Return to step 1. The removal of one bottleneck will create another elsewhere in the
system
Feedforward control
Feedforward control occurs when mangers forecast likely outcomes and then compare these with the
desired outcomes. Action can be taken in advance to correct any adverse situations or to take full
advantage of favourable situations.
For example, a cash forecast may show that an organisation is likely to have a negative cash position in
November and December, say. Managers can therefore take action now to avoid the situation if
necessary. They could, for example, postpone capital expenditure.
Feedforward control means that mangers are forewarned of any situation, whether it be good or bad,
before it occurs.
Feedback control
Feedback control involves recording actual results and then comparing them with forecast or budgeted
results. For example, a sales budget can act as a feedback control mechanism if the actual sales figures,
are compared with the budgeted sales.
Reasons for differences can be identified and efforts made to ensure that favourable differences continue
to be exploited and adverse differences do not occur in the future.
3
Budgetary slack refers to the practice of overstating budgeted costs and/or understating budgeted
revenues.
This has negative consequences for performance in that 'good' performance is difficult to measure
without a credible standard to benchmark against. For example, if budgets are set for sales at 10,000
units when the sales manager truly believes that sales can be as high as 12,000 units, then actual sales
of 11,000 units would actually be disappointing, despite the fact that this level of sales is above budget.
Also, budgetary slack can lead to the misallocation of resources. For example, if an activity which is
deemed essential has a budgeted cost of 1.2 million for the year, yet the manager believes it can be
done for 1.0 million then 200,000 which could have been allocated to other worthwhile activities, e.g.
training and preventative maintenance have been misallocated.
206
CHECKPOINT 3
Good news stories from the Irish manufacturing sector are thin on the ground, especially in the northeast, which
has been hit by a spate of job losses in recent months. Against this background it is remarkable that one
Donegal-based textiles firm claims to be enjoying one of its best years ever. Magee Weaving, a 150-year-old
family firm, is taking on cut-throat competitors from low-wage economies in this notoriously difficult sector and
winning.
The companys success can be attributed to the type of long-term planning that separates successful SMEs
(small- and medium-sized enterprises) from the also-rans. In the early 1990s Magee Weaving sensed the way
the wind was blowing in the global fashion industry and decided drastic action was required. The bulging order
book the company now enjoys is testament to the way that period of change was managed.
As might be expected, being in a traditional industry we managed our company along traditional lines, said
Sweeney. After a series of reviews of our organisation and market, we became convinced first of all of the need
for change, and arising out of that of the need for us to learn how to change, he said.
Sweeneys aim was to create a multiskilled and flexible organisation that was both innovative and adaptable.
Employees at all levels had to learn to adapt to new technology and improved quality standards. They were
introduced to industrial techniques such as world-class manufacturing and total quality management. Job
profiles were more clearly defined and a greater emphasis was placed on on- and off-the-job training.
We became a learning organisation, said Sweeney. The changes have given us a small, well-equipped,
modern, fast- response unit.
This proved to be the prerequisite for Magee Weavings fundamental change in strategy. In Europe we can
never compete on price. That period of change helped us move upmarket, allowing us to introduce a very high
design input.
Change is now continual for us because we have to be able to recognise where the market opportunities are
and the markets that can afford a European supplier.
Chief executives own final accountability. Shareholders want strong profit growth and minimum volatility.
Regulators and the press expect social and environmental responsibility. Customers demand someone deliver
on promises made to them. Supply chain management has become the key to meeting all of these commitments.
Most companies, especially in manufacturing and retail, but increasingly in the energy, entertainment, and
healthcare sectors, have seen supply chain management gain strategic importance in recent years. For those
wondering what good supply chain management is and how leading companies exploit it, AMR Research has
published, yearly since 2004, a report titled, "The Supply Chain Top 25".
This list features leading companies that have advanced supply chain from its roots in logistics, material
handling, and purchasing toward the modern, demand-driven value network needed in our globalised, Internetenabled, 21st century business environment.
Twentieth century business was largely built on a manufacturing economy of big assets tied up in factories and
production equipment. Supply chain management in this context meant feeding the factory and shipping finished
goods, acting only as a support function to the real business of making basic products for customers.
207
CHECKPOINT 3
Today's customers want goods that depend primarily on intellectual property (lifesaving molecules, entertainment
electronics, creative design) and are built by companies tapping a global network of specialists to bring
innovative things to people whose homes are already full of refrigerators, shoes, and shaving foam.
This demand-driven value network approach is exemplified by companies such as Nike (No. 18 in 2007), which
innovates with a brand and total consumer experience that supports high prices while keeping a close eye on
operations across a global manufacturing and distribution network. For those who think Nike is all about
marketing, consider that its supply chain has increased operating margins in each of the last four years: 2003,
10.5 per cent; 2004, 11.8 per cent; 2005, 13.5 per cent; and 2006, 14.3 per cent.
The same can be said of Nokia, with the top supply chain in the world, which excels at supplier collaboration
while still pushing technology and design innovation that reaches almost 1bn people worldwide. Along with Nike,
Procter & Gamble (No. 3), Coca Cola (No. 13), and all the other consumer products companies on the list,
Nokia's supply chain serves the chief executive's first master, shareholders, by doing more than just cutting
costs.
Nokia orchestrates the constant collaboration between supply, demand, and product management groups that
brings profitable new products to market. Nokia's share price has doubled in the past 12 months.
The principle does not only apply to companies selling to consumers. IBM (No. 4), Cisco Systems (No. 11),
Johnson Controls (No. 16), and Paccar (No. 24) sell almost exclusively to corporate customers. All, however,
also depend on the successful orchestration of supply (manufacturing, sourcing, logistics), demand (sales,
marketing, service), and product (R&D, engineering).
Each company has succeeded for shareholders by integrating processes that allow them to operate as demanddriven value networks: orchestrating players up and down the supply chain with a combination of information,
visibility, cross-cutting metrics, and market discipline.
Chief executives need to think of the supply chain not as a cost centre but as the orchestrator of a value network.
Our Top 25 has outperformed broader stock market indices by almost 100 per cent the 12 months following
release of the report each year indicating at least some link between good supply chain management and
increasing shareholder value.
Finally, consider accountability to the customer. Supply chains of the 20th century were inward looking,
concerned primarily with factory throughput and cost control. It took a decade of leadership from the likes of
Toyota (No. 5) to teach supply chains about quality. Today's best are looking for the next level to become truly
demand-driven. No. 3 Procter & Gamble calls it the "moment of truth" when a consumer chooses to buy and then
use a product. Everything in P&G's global value network is based on winning at this moment of truth.
Supply chain management has evolved from a low impact cost centre to the essential means to drive
shareholder value, global reputation, and customer satisfaction. CEOs interested in leaving a great legacy had
better understand how this change is happening and what they can do about it. For a start, look to these Top 25
leaders to see how their supply chain management strategies are evolving and why they are stealing the lead
from those who are still stuck in the 20th century.
Just as marriage partners often undergo a long process of discovery, so corporate partnerships can be an
enormous challenge.
Yet scarcely a day passes without a new set of corporate banns being read. In the whirl of alliances between
start-ups, software developers, systems integrators and telecommunications companies, partnering is endemic.
As Alan Mac Neela and Christine Adams, analysts at research house Gartner, observe: "During the past five
years, partnering has become routine in IT - so much so, it is now the cornerstone of many providers' go-tomarket strategies."
208
CHECKPOINT 3
In Amsterdam, Ron Tolido, chief technology officer for Continental Europe and Asia at consultancy and systems
integrator Capgemini, "I would argue that nowadays complex clients no longer believe in the capability of a single
company to deliver a single solution," he says. "From our perspective our market demands collaboration from
several partners for bigger deals. The demands of the client are normally shaping the way we collaborate."
In Boston, Michael O'Hara, general manager of the communications sector at Microsoft, highlights the ways he is
working with US cable company Comcast to deliver $10-a-month e-mail solutions for small businesses. At the
same time, a partnership with Orange, the Paris-based mobile arm of France Tlcom, puts Microsoft's
advertising-funded instant messaging on Orange phones, giving a combined audience of 370m potential users.
In any list of key partners provided by a systems integrator or a telco, the same names recur: Microsoft, SAP,
Hewlett-Packard, IBM, and so on.
Yet the depth of these partnerships varies. Mr Tolido says Capgemini creates "partnerships for a particular
opportunity" according to the skills and technology required. Yet even if IBM is spurned for a particular deal, the
underlying thread of collaboration must remain strong.
Finding patterns in all this collaboration is not easy. Gartner's Mr Mac Neela and Ms Adams say there are
multiple motivations: "Some partnerships are primarily revenue-driven - for example, to expand reach, extend the
sales force, increase exposure, enable access to new, emerging or adjacent markets. Other partnerships are
portfolio-centric, such as to create a more compelling or credible offering or solution, or access specialised skills
or expertise."
Customer pressure can create unlikely pairings. A partnership agreement in 2006 between Novell and Microsoft
to make the Linux open-source operating system work better with Microsoft's Windows - and sell the two jointly
where appropriate - shocked the software industry.
The idea that Microsoft would work with Novell to make Linux, the historic arch-rival of Windows, interface more
easily was seen as a sign that Windows' bid for world domination was dead. In practice, the accommodation
recognises that the two operating systems will co-exist for many more years, and that both may profit if they work
better together.
A year on, Susan Heystee, general manager for global strategic alliances at Novell, says the partnership has
generated revenues of $105m. Meanwhile, Novell's Linux revenues have separately grown almost two and a half
times. The pair celebrated the partnership's birthday by naming 30 new clients, from car-maker BMW to the City
of Los Angeles. The positive response of customers, she says, proves the tie-up answered an un-met business
need.
Significantly, it is demand from large corporations for simple, sustainable and low-risk relationships with a
reduced number of suppliers that drives many IT industry partnerships.
Orange has partnered Research in Motion, for example, the Canadian manufacturer of the BlackBerry
smartphone, in a deal that enables them to roll-out and support new BlackBerry devices more quickly to a bigger
market of European users.
LogicaCMG, another integrator, partners BT in supplying clever, secure corporate data and e-mail. Kevin Duffy,
UK sales and marketing director, at LogicaCMG, says his company can thus leverage BT's marketing strength to
access its clients in a high-speed roll-out it could not have managed alone, while BT gets to offer clients superior
technology.
For technology start-ups, partnering provides market access, without the expense, before the solution is
overtaken by other technologies.
In practice, partnerships and acquisitions are not mutually exclusive. Companies may prefer acquisitions in areas
where they are technically competent, but partnerships where they are not. Steve Cash, General Manager for
Partnerships at BT makes the point: "We will always have M&A activity as well. The BT Group has made 17
acquisitions in the past 12 months."
When it comes to big picture telco-software convergence, partnerships are the low-risk option. BT's global
alliance with HP is an example. But Lucy Dimes, managing director of the BT/HP Alliance, reckons even a
company the size of BT can manage only two or three of that intensity.
209
CHECKPOINT 3
Such deals require global competitors to share a vision about the future of markets and technology in areas
covered by the partnership. They need a meeting of minds between chief executives - Nortel's Mike Zafirovski
gets on well with Microsoft's Steve Ballmer; BT's Ben Verwaayen and HP's Mark Hurd talk the same language.
The partnership vision then has to be shared down the hierarchy and built into a common business. Partnership
managers list three keys to success besides commitment from the top: sufficiently different partners so that
existing overlap is limited; a shared vision for the partnership; and an operating model focused on exploiting
opportunities, without worrying about which partner gains most.
Most reckon it takes a year or two of trust building before such partnerships really start to deliver. "It can take
time before you share market data and assumptions," says Ms Dimes. "People don't always want to open the
kimono with strangers, but once you get into the process, confidence grows."
210
Performance Evaluation
Variance Analysis
11a
211
Overview
Performance Evaluation
- Variance analysis
Interpretation of
variances
Traditional variance
proformas
212
Interpretation of variances
1.1
One of the tools available to a business to assess how well it is performing in various areas
is variance analysis.
Key to evaluating performance is not just being able to calculate the variances, but to
interpret and draw meaningful conclusions from the variances.
Causes of variances
1.2
Obviously the cause of the variance must be determined before appropriate action can be
taken. An employee should only be judged on what they have control over.
Interdependence of variances
1.3
1.4
For example, a decision to purchase better quality, higher price materials may result in an
adverse price variance but a favourable usage variance.
1.5
The following table may help you to think about some of the operational causes of
variances.
Variance
Favourable
Adverse
Material price
Price increase
Careless purchasing
Defective material
Labour rate
Idle time
Labour
efficiency
Machine breakdown
Illness or injury to worker
Lost time in excess of standard
Material
usage
213
Favourable
Adverse
Fixed
overhead
expenditure
Fixed
overhead
volume
Sales price
Sales volume
Fall in demand
Lower output
Lecture example 1
Idea Generation
Required
Discuss instances when a favourable variance may not be good news and when adverse
variances may be good for a business.
Solution
214
2
2.1
Should
Should now
Did
215
Lecture example 2
The following data relate to product AJ and its material content for the month of June.
Budget
Output 15,000 units of AJ
Materials 4kg per unit @ $9 per kg
Actual
Output 14,000 units of AJ
Materials 54,000 kg @ $9.50
It has now been agreed that the standard price for the raw material purchased in June should have
been $9.30 per kg and the standard kg / unit should have been 3.8 kg.
Required
Calculate the planning and operational material variances.
Solution
216
217
Where inputs can be substituted for one another, the efficiency/usage variance can be
subdivided.
The materials and labour variances can both be split into mix and yield (or output)
components.
3.2
The mix variance represents the financial impact of using a different proportion of raw
materials.
3.3
The yield variance represents the financial impact of the input yielding a different level of
output to the standard.
Lecture example 3
River Tyne Foods Co (RTF) is a manufacturer of frozen meals. It is reviewing the performance of
its main product, the Rumble. RTF operates a standard absorption costing system and the
following budget revenue and cost data per unit of each Rumble is as follows.
Selling price
Material A (sauce)
Material B (meat)
Material C (vegetables)
Labour
Fixed Overheads
125g @ $2/kg
200g @ $5/kg
75g @ $0.80/kg
0.05hrs @ $15/hr
0.05hrs @ $12/hr
218
Rumble ($)
3.99
0.25
1.00
0.06
0.75
0.60
kg
Costing ($)
27,555
45,905
12,675
58,000
239,375
10,000
Required
Calculate the mix and yield variances for the Rumble in Quarter 3.
Solution
219
These variances give us more insight as to what has caused the material usage variance,
but as with all variances, conclusions / recommendations need to consider the impact on
other affected areas for example, materials price, labour efficiency and sales volumes.
Lecture example 4
An extract from an operating statement prepared in a frozen food manufacturing facility shows the
following variances for quarter 1:
$
Materials prices variances
Material A
Material B
Materials mix variance
Material A
Material B
Materials yield variance
Materials usage variance
1,568 F
815 A
641 A
1,399 F
2,320 A
1,562 A
Required:
Evaluate the performance of the purchasing and production managers
Solution
220
5
Q11 Mills Ltd
Chapter summary
Section
Topic
Summary
Interpretation of
variances
Planning and
operational
variances
Traditional
variances overview
221
END OF CHAPTER
CHPATER
222
11a
Additional notes brought forward C1 knowledge
223
4.1
Sales volume
Sales revenue
Cost of sales:
Materials
Labour
Overheads
Profit
Original budget
X
$
X
Flexed budget
X
$
X
X
X
X
X
Budgeted units
standard cost or
selling price per
unit
X
X
X
X
Actual units
standard cost or
selling price per
unit
Sales variance
Material variance
Labour variance
Overhead variance
Actual results
X
$
X
X
X
X
X
Actual units
actual cost or
selling price per
unit
If your memory is hazy on the area of variances, please review the proformas below.
Additionally, you should work through the online study resource for this area.
4.3
Material variances
Price
Actual purchases should cost
Should
Actual purchases did cost
Did
Usage
Should
Did
4.4
$
X
(X)
X
Kgs
X
(X)
X
$X
Labour variances
Rate
Should
Did
Efficiency
Should
Did
Idle time
Should
Did
$
X
(X)
X
Hrs
X
(X)
X
$X
Hours worked
Hours paid
Difference valued at standard rate per hour
224
Hrs
X
(X)
$X
Expenditure
Should
Did
Efficiency
Should
Did
X
(X)
X
Hrs
X
(X)
X
$X
NB: This assumes variable overheads are incurred per labour hour.
4.6
4.7
Volume variance
Budget expenditure
Actual expenditure
$
X
(X)
X
Units
X
(X)
X
$X
Sales variances
Price
Should
Did
Volume
Should
Did
225
$
X
(X)
X
Units
X
(X)
X
$X
END OF CHAPTER
CHPATER
226
Performance evaluation
11b
Assessment of profitability of a
business and resulting advice has
been required.
227
Overview
Performance
evaluation
Ratio Analysis
Profitability
Liquidity
Non-financial
performance indicators
Benchmarking
Balanced
scorecard
228
Ratio analysis
1.1
1.2
The income statement, the balance sheet and forms of divisional income statements used
by the management of business enterprises are all sources of useful information about the
condition of the business.
1.3
The analysis and interpretation of these statements can be done by calculating certain ratios
and then using the ratios for comparison, either:
(a)
(b)
between one year and the next for a particular business or division; or
between one business or division and another.
Indicators of profitability
2.1
Net profit
100 %
Sales
A high profit margin indicates that either sales prices are high or total costs are being kept
well under control.
2.2
(Sales COS)
Sales
100 %
A high gross profit margin indicates that either sales prices are high or production costs are
being kept well under control.
2.3
Asset turnover
229
Lecture example 1
Preparation question
The following figures are extracted from the accounts of Big Bond plc.
Total production cost
Gross profit for the year
20X9
$3,269,000
$1,503,000
20X8
$2,541,000
$1,291,000
$295,000
$3,005,500
260
29,361
$287,000
$2,861,000
248
27,498
Required
(a)
(b)
ROCE
20X9 data for Little Boots, a competitor of Big Bond is available and is as follows:
Gross profit margin
35%
15%
ROCE
12%
17,000
$90
Solution
230
231
3.1
The current ratio can be calculated by dividing the most liquid assets in the business
(receivables, inventories and cash) by the business' payables.
Current ratio =
3.2
The current ratio can be amended by excluding the inventory from the current assets. This
gives the quick ratio or acid test.
Quick ratio =
3.3
Current assets
Current liabilitie s
The operating cycle or cash conversion cycle is a measure in time of how long cash is
tied up in operations (ie the period between paying for raw material inputs and receiving the
cash for the ultimate sale of finished goods). It is effectively the sum of the working capital
periods (receivables and inventories) less the payables period. It is calculated as follows.
1
Receivables period
Inventory period
Average receivables
Credit sales
365
days
(a)
Finished goods
365
days
(b)
WIP
Average WIP
Cost of production
365
days
(c)
Raw material
365
days
Average payables
Credit purchases
365
(days)
By comparing the operating cycle from one period to the next, or one company to another, it
should be possible to identify potential deficiencies. The period can be quantified in months
by multiplying the fractions by 12.
232
Lecture example 2
Preparation question
The table below gives information extracted from the annual accounts of KLM plc for the past year.
KLM plc Extracts from annual accounts
20X9
($)
96,000
103,500
75,400
623,000
715,000
743,500
875,000
243,800
75,000
(a)
Calculate the length of the operating cycle (assuming 365 days in the year).
(b)
The operating cycle of a competitor of KLM is 156 days. In the light of this information what
conclusions can you draw from the length of KLMs operating cycle?
Solution
233
Horizontal analysis
ie line by line comparison of data with another (eg. accounts with prior year, budget or
another company).
(b)
Trend analysis
Vertical analysis
5.1
(a)
Focus only on variables which can be expressed in monetary terms ignoring other
important variables which cannot be expressed in monetary terms
(b)
Focus on past
(c)
(d)
234
Definition
6.1
NFPIs are measures of performance based on non-financial information which may originate
in and be used by operating departments to monitor and control their activities without any
accounting input. As with all performance indicators, the most effective NFPIs will be both
specific and measurable.
Examples
6.2
Performance measures
Service quality
Number of complaints
Proportion of repeat bookings
On-time deliveries
Customer waiting time
Production performance
Set up times
Number of suppliers
Days inventory in hand
Output per employee
Materials yield percentage
Production schedule adherence
Output requiring reworking
Manufacturing lead times
Marketing effectiveness
Personnel
Different industries will place a different weighting on each area depending on those most
critical to their success.
235
Value of NFPIs
6.3
(a)
Information can be provided quickly for managers (eg per shift, daily or hourly)
unlike traditional financial performance reports.
(b)
(c)
Easy to calculate and easier for non-financial managers to understand and use
effectively.
(d)
(e)
(f)
Provide better information about key areas such as quality, customer satisfaction,
employees, and so on.
(g)
Better indicator of future prospects than financial indicators which focus on the
short term
(a)
Too many measures can lead to information overload for managers, providing
information which is not truly useful.
(b)
May lead managers to pursue detailed operational goals at the expense of overall
corporate strategy.
(c)
(d)
236
Balanced scorecard
7.2
The balanced scorecard focuses on four different perspectives and aims to establish goals
for each together with measures which can be used to evaluate whether these goals have
been achieved.
Analog Devices
Balanced Scorecard
Customer
Internal
Innovation &
Learning
Financial
7.3
Perspective
Question
Customer
Internal
Innovation and
learning
Financial
237
The scorecard is 'balanced' in the sense that managers are required to think in terms of all
four perspectives, to prevent improvements being made in one area at the expense of
another.
7.5
The method has the advantages of looking at both internal and external matters
concerning the organisation, and of linking together financial and non-financial measures.
7.6
Disadvantages of this will arise from the selection and interpretation of appropriate
measures, and any potential conflicts between measures (eg R&D expenditure).
Lecture example 3
Required
Recommend one performance measure for each of the four perspectives of the balanced
scorecard for a restaurant. State the reason for your choice of measure.
Solution
238
Benchmarking
8.1
A business will attempt to seek the best available performance against which it can measure
its own performance. By adopting what is regarded as best practice as a target, the
business attempts to improve its own performance. In this way, the business can be as
good as, or better than, the best in the world in the most important areas of operation.
8.2
Benchmarking uses a realistic target for improving the operations of the business. It can
benefit from the knowledge and practices of other businesses, without having to make all its
own mistakes, and it can obtain a competitive advantage.
Benchmarking is now widely used in not-for-profit organisations, such as the public sector.
8.3
(b)
8.4
8.5
reverse engineering
intra group (companies in same industry)
inter industry (non-competing businesses with similar processes)
(b)
Data is likely to be more relevant, since it will reflect the companys existing systems,
policies and working practices.
(c)
Information will be available to help the organisation understand how to make the
move to best practice in one department because they will have access to what is
going on behind the scenes in another department. This may not be the case with
external benchmarking in which the data available is often restricted to a snapshot of
outputs only.
Establishing what makes the difference, in their customers' eyes, between an ordinary
supplier and an excellent supplier
(b)
Setting standards in each of those things, according to the best practice that can be
found
(c)
Finding out how the best companies meet those challenging standards
(d)
Applying both other people's experience and in-house ideas to meet the new
standards, and, if possible, to exceed them
239
Companies worldwide have found that there are very significant gains to be made from
benchmarking including the following.*
(a)
(b)
(c)
(d)
(e)
(f)
* source: DTI
Objectives
9.1
(a)
(b)
(c)
(d)
(e)
ensure survival
provide a quality product/service (customer satisfaction)
be a good corporate citizen (health and safety/environment)
create wealth/benefits for management/employees
secure competitive advantage and grow market share
The objective of profit or wealth maximisation is thus modified to meet the needs of different
interest groups (stakeholders).
9.2
9.3
(a)
(b)
(c)
(d)
earn sufficient profits to provide for future capital investment and perhaps provide a
surplus for the exchequer
240
Evaluation of performance
9.4
NFPOs and public sector organisations will not have wealth maximisation as a primary
objective. However, they will still have strategic objectives (albeit non-financial) and
stakeholders (clients, members etc), who will wish to measure their performance.
9.5
Multiple objectives
How to measure output
Lack of financial / profit measure
Difficult to define a unit
Lecture example 4
Idea Generation
Required
(a)
(b)
Highlight the problems that may occur in attempting to monitor performance of the hospital
using league tables of this data over time and against other hospitals.
Solution
241
9.7
(a)
The 3 Es
(b)
(c)
(d)
Economy
Lecture example 5
Idea Generation
Required
Using the 3 Es suggest a range of performance measures for a public sector higher education
college.
Solution
242
10 Chapter summary
Section
Q12 Silk Imports
Topic
Summary
Ratio analysis
Indicators of
profitability
Liquidity/working
capital ratios
Approaches to
performance
evaluation
Non-financial
performance indicators
(NFPIs)
Balanced scorecard
Benchmarking
243
END OF CHAPTER
244
Measuring performance in
responsibility centres
12
245
Overview
Measuring performance in
responsibility centres
Decentralised
organisations
Responsibility
accounting
Investment centre
performance appraisal
methods
RI
ROI
246
EVA
Section 1
Responsibility
Centres
Decentralised organisations
1.1
This chapter deals with decentralised organisations, ie those where managers at lower
levels of an organisation have a degree of autonomy, giving them control over decisions and
activities.
1.2
Objectives
(a)
(b)
(c)
(d)
1.3
1.4
Disadvantages of decentralisation
(a)
(b)
(c)
Provide incentive to the divisional manager to make decisions which are in the best
interests of the overall company (goal congruence)
(b)
Only include factors for which the manager (division) can be held accountable
(c)
Responsibility accounting
1.7
247
Manager's area of
responsibility
Typical financial
performance measure
Cost centre
Revenue centre
Revenues only
Revenues
Profit centre
Controllable profit
Investment centre
Transfer pricing
1.9
The transfer pricing policy (Chapter 13) will have a significant impact on responsibility
accounting and performance measurement.
Lecture example 1
Preparation question
The following figures for the years ending 31 December 20X4 and 20X3 relate to the B and C
divisions of Cordeline.
The return on capital employed (ROCE) figure is the basis for awarding a 20% bonus to the
manager of B division (actual ROCE/target ROCE). The below target ROCE for C division has
resulted in a zero bonus award to its manager.
Division
Sales
Profit before interest and taxes (PBIT)
Included in profit calculation:
Depreciation for year
Net book value (NBV) of non-current assets
New investment in non-current assets
Original cost of non-current assets
Return on capital employed
Target return on capital
20X4
$'000
9,850
1,336
960
5,540
500
12,600
24%
20%
20X3
$'000
7,243
1,674
20X4
$'000
4,543
924
919
6,000
750
12,100
28%
20%
1,300
7,700
6,400
9,500
12%
20%
20X3
$'000
2,065
363
Required
Describe the possible counter-productive behaviour resulting from using the current ROCE
calculation for performance appraisal
248
251
2,600
2,400
3,100
14%
20%
Solution
These give a good indication of the managers ability to control costs and operations but do
not relate these costs to the size of investment made in the division.
In an investment centre we therefore need some alternative performance measures.
249
ROI is a very similar measure to the ROCE figure used in corporate analysis.
ROI =
2.4
If it is not possible to calculate controllable profit from the information given in the question,
you should use profit before interest and tax (PBIT). For the divisional investment total
assets less current liabilities should be used.
2.5
2.6
Decision rule
Only projects which increase the existing ROI should be undertaken.
Lecture example 2
Brenda and Eddie have two franchises in different parts of town and want to monitor the
performance of the two managers who have full control over investments.
Forecast results for the year are:
Vittorios
$
90,000
500,000
Profits
Investment
Dugaldos
$
135,000
750,000
Vittorio is considering investing in a labour-saving piece of equipment which will cost $8,000. This
will generate an increase in net profit of $1,200 each year for 10 years, after which time the
equipment is expected to have no resale value. Vittorio uses straight-line depreciation.
Dugaldo has been offered a replacement oven for one of his existing ones. The existing one is
written down in the books to an NBV of $2,000 but is very inefficient. Its maintenance and
depreciation costs are $25,000 p.a.
The replacement will cost $75,000, will have no downtime and negligible maintenance costs in its
early years. Depreciation will be 20% p.a. straight-line.
Each oven is estimated to generate $60,000 p.a. before these costs are considered.
Required
(a)
Would profit or ROI be more equitable for comparing Vittorio's and Dugaldo's forecast
performance?
(b)
Show why, in each case, ROI (based on opening book values) will lead to dysfunctional
decisions. Brenda and Eddies group ROCE is 12%.
250
Solution
2.7
The main reason that these dysfunctional decisions arise is that ROI is a relative measure
(i.e. a ratio) and masks the absolute effect on profits.
Disadvantages
May lead to dysfunctional behaviour only projects which increase ROI will be
accepted, this could be at the expense of
growth in corporate profits.
Residual income
2.9
Traditionally the main alternative to ROI. It provides a hurdle figure for profit based on the
companys minimum required percentage return from a division.
Controllable divisional profit (usually PBIT)
less: "imputed interest" (= Divisional Investment Cost of Capital)
Residual income
$
X
(X)
X
Lecture example 3
Required
Solution
Disadvantages
Based on profit
252
ROI vs RI
3.1
As can be seen from the above example, residual income appears to be technically
superior.
Return on investment
3.2
In practice, however, ROI is used more frequently than RI, for the following reasons.
(a)
(b)
(c)
(d)
(a)
(b)
(c)
(d)
(e)
Calculation of 'investment'
3.4
(a)
(b)
(c)
(d)
3.6
Advantages
Disadvantages
253
4.1
where the capital charge = weighted average cost of capital net assets.
[if net assets is not given it should be calculated as non-current assets plus working capital].
Questions over
new star
4.2
EVA is a financial performance method to calculate the true economic profit of a company,
ie the residual wealth it creates.
4.3
It shows the amount by which earnings exceed or fall short of the minimum rate or return
that investors could get by investing elsewhere.
4.4
It is based on the idea that a business must cover both its operating and capital costs: until
a business returns a profit that is greater than its cost of capital it operates at a loss. Peter
Drucker.
In order to add to its economic value a business must make an economic profit in excess of
the cost of capital that has been invested to earn that profit.
4.5
Calculation:
(a)
(b)
Interest excluded
254
Lecture example 4
Division D operates as an investment centre. The book value of the non-current assets is $83,000
but their replacement value is estimated to be $98,000. Working capital in the division has a value
of $19,000.
Latest operating profits for the division were $18,500, after charging historical cost depreciation of
$8,100 and the costs of a major advertising campaign which amounted to $6,000. The advertising
campaign is expected to boost revenues for three years.
An economic depreciation charge for the period would have been $12,300.
The risk adjusted weighted cost of capital for the company is 11% per annum.
Required
Solution
If, as in Lecture example 4, we are given a replacement value for the non-current assets we can
deduce that this relates to the assets held on our balance sheet.
Some questions may be worded in such a way that implies the replacement cost of all assets may
include any deferred advertising spend. If this is the case we do not need to adjust the assets
again.
If you are unsure, state your assumption.
255
Advantages of EVA
4.6
(a)
(b)
EVA may be less distorted by the accounting policies selected as the measure is
based on figures that are closer to cash flows than accounting profits
(c)
(d)
EVA recognises costs such as advertising and development as investments for the
future and thus they do not immediately reduce the EVA in the year of expenditure
(e)
Disadvantages of EVA
4.7
(a)
(b)
EVA is based on historical accounts which may be of limited use as a guide to the
future
(c)
(d)
Investment centres which are larger in size may have larger EVA figures for this
reason. Allowance for relative size must be made when comparing the relative
performance of investment centres
Lecture example 5
Required
Explain how using EVA might result in beneficial action being taken by management.
Solution
256
Lecture example 6
Required
Explain and discuss the similarities and differences between Residual Income and Economic
Value Added as methods for assessing the performance of divisions
Solution
Q13
Y&Z
257
Chapter summary
Section
Topic
Summary
Decentralised
organisations
ROI v RI
EVA
END OF CHAPTER
258
13
Transfer pricing
Discussion of implications on
transfer price when a division is
located overseas or how transfer
pricing can be used to minimise
a companys tax charge.
259
Overview
Transfer pricing
International aspects
Aims
Approaches
Market-based
Cost-based
Actual
Standard
Full cost plus
Variable cost plus
Dual pricing
Two part tariffs
260
Opportunity cost
Transfer pricing
1.1
Within a decentralised organisation there may be a division which makes units that are then
transferred to another division. It will usually be necessary to charge the receiving division
for the goods that it has received in order for performance to be measured equitably.
A transfer price is the price at which goods are transferred internally.
1.2
It is vital that the transfer price is carefully selected to ensure all parties act in the best
interest of the company.
Costs
incurred by
Supply
WHOLE COMPANY
Division
Supply
Transfer?
Division
Receive
Revenue
earned by
Receive
261
Market-based approaches
2.1
If an external market exists for transferred goods (and there is unsatisfied demand
externally), the transfer price can be set as the external market price.
2.2
Seller
Buyer
If savings are made by selling internally then this may be reflected in the transfer price, eg
by offering a discount equivalent to saved transport costs.
Cost-based approaches
2.4
The idea behind these approaches are similar to those involved in manufacturing accounts,
The supplying division has its costs of manufacturing refunded and may also be given a
mark up to encourage the transfer.
Full Cost
Seller
Buyer
262
Variable cost
Seller
Buyer
If a transfer price is based on marginal or variable cost the supplying division does not cover
its fixed costs. Two alternative approaches to overcome this problem are dual pricing and
two part tariff.
Dual pricing
2.9
Seller
Buyer
In a dual pricing system, different prices are used by each division. The selling division is
credited with a price that will allow them to earn an appropriate profit (often the external
market price if one exists) and the buying division is debited with the variable or marginal
cost only.
The balancing figure between the two will be debited to a group account and, at the end of
the year, incorporated to consolidate out the difference and arrive at the correct group profit.
Two-part tariff
2.10
Seller
Buyer
263
Buyer
Buyer
Lecture example 1
Goods are transferred from Division S to Division R at standard full cost + 10%.
Division S
$
20.00
8.00
28.00
2.80
30.80
Variable costs
Fixed overhead
Standard profit @ 10%
Transfer price
Solution
264
or
Opportunity cost
(i)
If an external market exists for the intermediate product, opportunity cost is equal to
contribution foregone
(ii)
If no external market, the opportunity cost is likely to be nil. Opportunity cost is likely
to exist however if the company is at full capacity on another task.
2.14 Opportunity cost-based approaches should always result in goal congruent behaviour with
both buyer and seller happy to transfer when it is in the group's best interest to do so.
265
Lecture example 2
A profit centre produces three products, Eee, Buy and Eck. Each product has an external market,
but Buy can also be transferred to Division B.
After incurring extra costs of $60, Division B then sells the unit for $300.
The maximum quantity that might be required for transfer is 150 units of Buy.
Information on the products is as follows.
Eee
$150
$86
4
2,000
Buy
$200
$95
6
1,250
Eck
$140
$83
3
2,400
In the current period, labour hours in the profit centre are limited to 20,000, and this is insufficient
to satisfy maximum external demand.
Therefore, using limiting factor analysis, the optimal production plan has been calculated as:
Eee
$64
4
$16
3rd
Hours/unit
3
6
4
Buy
$105
6
$17.50
2nd
Eck
$57
3
$19
1st
Hours
7,200
7,500
5,300
20,000
Required
Given that the profit centre is operating at full capacity, calculate an appropriate range of transfer
prices for a unit of Buy.
Solution
266
267
Lecture example 3
60
150,000
5,000
900,000
Calculate the profit generated by each division, profit margin and ROI
Solution
268
Division 2
$
230
80
150,000
3,000
850,000
Discuss the changes to the performance measures and their implications for the divisions as
a result of changing the transfer price to full cost plus 25%.
Solution
269
Lecture example 4
TCr
$
60
125
195
270
350
Required
Determine the optimal transfer policy.
Solution
270
NMRr
$
GSK settles
largest tax
dispute in history
3.1
The problems encountered in setting transfer prices are compounded when a group has
subsidiaries operating in different countries.
Taxation
3.2
Double taxation agreements between countries mean that companies normally pay tax only
once, in one country, when they transfer goods from one division to another across national
borders. (A division is a wholly owned subsidiary in this instance.)
3.3
3.4
If the manufacturing division were in a low tax country and the marketing division in a high
tax country, the opposite would apply.
3.5
But setting a transfer price on this basis in unwise. If a tax authority feels that a company is
using an unrealistically high, or low, transfer price to reduce its liability, it can substitute an
'arms-length' price in place of the company's transfer price and tax will be paid in both
countries, double taxation.
3.6
Most countries now accept the Organisation for Economic Co-operations and
Developments (OECD) guidelines. They provide guidance on arriving at an arms length
price. However, it can still be difficult to arrive at a suitable transfer price particularly for
intangible property. The onus is now on the taxpayer to demonstrate that the transfer price
is reasonable, failure to do so can result in large penalties.
As a result taxpayers may enter into an Advanced Pricing Agreement (APA) with the
relevant tax authorities. The agreement as made in advance will avoid any disputes and
therefore avoid double taxation and penalty fees.
Repatriation of funds
3.7
Exchange controls may prevent the transfer of profit overseas. Transfer prices could
therefore be used to move funds between countries.
3.8
If a county has high inflation, its funds will lose value, but if they can be repatriated the loss
in value is prevented.
3.9
If import duties exist, it would be advantageous to keep the transfer price as low as possible
to avoid high duty payments
Minority shareholders
3.10 Transfer prices can also be used to reduce the amount of profit paid to minority
shareholders by deliberately lowering a subsidiarys profit.
271
Currency management
Section 9.3
Currency
management
3.11 An additional consideration when setting transfer prices internationally is which currency the
transfer should be made in. Any movements in exchange rates could result in gains or
losses on exchange.
Lecture example 5
The existing results of Green Group are given below. Division S makes units to be transferred to
Division R.
Division R has no other sales besides the sale of transferred units.
Note that Division S is located in a high tax country, and Division R is in a low tax one.
$'000s
Internal sales
External sales
Less:
Internal costs
External costs
Division S
500
Divisional profit
Tax
Profit
Division R
1,100
(200)
(500)
(100)
300
@ 30% (90)
210
500
(25)
475
@ 5%
The new tax manager of Green Group has suggested a change in the transfer pricing policy, so
that the internal transfer is made at cost price of $200k.
Required
Evaluate the effect of this change in policy on:
(a)
(b)
Division S
Green Group
Solution
272
273
4
Q14
FP Photocopiers
& Q15
PCs R Us
Chapter summary
Section
Topic
Summary
Introduction to transfer
pricing
Transfer pricing in
practice
International aspects
END OF CHAPTER
274
CHECKPOINT 4
Take some time to reflect on the knowledge and skills you covered during Stage 4. If you feel you need further
clarification on any of the key areas listed below you can use the on-line lecture for the relevant chapter. The
Course Notes section for each chapter (starting overleaf) provides helpful guidance (and time commitments) on
how to focus your review on the key learning points in your notes.
Key knowledge
Performance measurement
In the modern business environment it has become evident that financial measures are insufficient on their own
and need to be supplemented with a range of non-financial indicators. The balanced scorecards is a key
technique which enables both financials and non-financials to be measured.
Decentralised organisations
Companies benefit in many ways by adopting this structure, but in so doing they expose themselves to the
problems that can stem from a lack of control. It is vital that companies implement appropriate performance
evaluation systems to encourage the right behaviours.
Investment centres
There are three main measures used to evaluate performance in investment centres: Return on Investment,
Residual Income and Economic Value Added. You should be prepared to discuss the implications of these
measures as well as being able to calculate them.
Transfer pricing
An organisation will want to know which of its many divisions are performing well and which are performing
poorly. This is often done by evaluating divisional profits, and divisional profits will be directly affected by transfer
prices if goods and services are provided by one division to another. You have seen several different
approaches to setting transfer prices, and you need to understand when a particular approach is appropriate,
and the behavioural impacts on the buyer, seller and company of each policy.
Key skills
You will have now covered the necessary knowledge of P2. Try also to remember the necessary key skills
discussed so far and more importantly to start to practice these particularly as you approach your course exam.
Play to your strengths so answer those questions you find easiest first
Ensure that when answering calculation elements you tackle the easy numbers first
Carefully present your answers so that they are clear, easy to follow and workings are cross referenced to
your answer.
Ensure written answers explain a point concisely but in full and relate them to the scenario given
wherever possible.
275
CHECKPOINT 4
175 mins
Key areas - use the online lectures to selectively review these if you need to
Course Notes
Ensure you are can suggest possible causes for variances achieved and can explain the reason for
planning and operating variances.
Run through the lecture examples again to ensure you are happy with the calculations
Review the additional notes section to ensure you can remember the variance pro-formas
Question Practice
Attempt Question 11 from the Question and Answer Bank in the back of the course notes if you feel
you need further practice on this brought forward knowledge area.
Additional Resources
Brought forward knowledge
Variance analysis variances are still examinable in the P2 syllabus and could be examined in many
ways including via an assessment of performance, with flexed budgets or with learning curves. An
online lecture is available to cover this.
10 mins
20 mins
10 mins
35 mins
100 mins
60 mins
Key areas - use the online lectures to selectively review these if you need to
Course Notes
Ensure you are comfortable with the various ratios in this chapter.
Discussions on performance measurement often focus on the use of non financial performance
indicators so ensure you are comfortable with this area and can suggest suitable performance
measures.
Question Practice
Attempt Question 12 from the Question and Answer Bank in the back of the course notes to practise
discussion and interpretation of performance.
Additional Resources - Real-life examples
It is recommended that you read the article about the use of non financial performance indicators and
the balanced scorecard contained at the end of this checkpoint.
276
10 mins
10 mins
35 mins
5 mins
CHECKPOINT 4
120mins
Key areas - use the online lectures to selectively review these if you need to
Responsibility accounting
ROI v RI
EVA
Course Notes
Run through the examples in this chapter again to ensure you are happy with these techniques
Be prepared to compare and contrast these techniques as this is often a discussion requirement.
Question Practice
Attempt Question 13 from the Question and Answer Bank in the back of the course notes. This
question has a good mix of both calculations and discussion on this area of the syllabus. Its important
to plan your answer for part (a) to ensure you can capture as many of the available marks as
possible.
Additional Resources
Brought forward knowledge
Investment appraisal techniques such as NPV and IRR are still examinable in the P2 syllabus and
could be examined via a comparison with ROI. An online lecture is available to cover this.
Study Text
Read through section 1 which provides further information on responsibility centres.
If you need further practice at EVA, work through the example in section 5. (Should take 10 mins)
Real-life examples
A brief article at the end of this checkpoints details how EVA is being used to decide which
companies to invest in. (2 mins)
15 mins
5 mins
60 mins
35 mins
5 mins
60 mins
Key areas - use the online lectures to selectively review these if you need to
Transfer pricing
Behavioural impacts
Course Notes
Ensure you can discuss the likely impact on both the buying and selling division of setting a transfer
price at actual cost, standard cost, variable or full cost, selling price or opportunity cost.
10 mins
Numeric questions often focus on calculating profits within divisions when given transfer prices are in
place so revisit Lecture Example 4.
10 mins
Implications of transfer pricing in overseas divisions is also commonly examined, so make sure you
review this area.
5 mins
Question Practice
Attempt Question 15 from the Question and Answer Bank in the back of the course notes.
Understanding the implications of transfer pricing is vital for P2.
Additional Resources
Study Text
Review of section 9.3 is strongly recommended which looks at currency management when setting a
transfer price between countries with differing currencies.
Real-life examples
It is strongly recommended that you review the article at the end of this checkpoint which looks at the
implications for GlaxoSmithKline of using a transfer price to manipulate their tax bill
277
20 mins
10 mins
5 mins
CHECKPOINT 4
278
CHECKPOINT 4
Division X of Tina Pease Ltd produced the following results in the last financial year:
Net profit
Capital employed:
fixed assets
net current assets
000
360
1,500
100
For evaluation purposes all divisional assets are valued at original cost. The division is considering a
project which will increase annual net profit by 25,000 but will require average stock levels to increase
by 30,000 and fixed assets to increase by 100,000. Tina Pease Ltd imposes an 18% capital charge on
its divisions.
Given these circumstances, will the evaluation criteria of Return on Investment (ROI) and Residual
Income (RI) motivate Division X management to accept the project?
A
B
C
D
2
ROI
RI
Yes
Yes
No
No
Yes
No
Yes
No
(2 marks)
Division W of Stoak Ltd produced the following results in the last financial year:
Net profit ($000)
Gross capital employed ($000)
200
1,000
For evaluation purposes all divisional assets are valued at original cost.
A proposed project will increase the division's net profit by 22,000, but will require gross assets to
increase by 100,000. Stoak Ltd imposes a 20% capital charge on its divisions.
Will the evaluation criteria of Return on Investment (ROI) and Residual Income (RI) motivate division W's
managers to accept the project?
ROI
RI
Yes
Yes
Yes
No
No
Yes
No
No
(2 marks)
279
CHECKPOINT 4
Which of the following definitions best describes the responsibility of an investment centre in a
decentralised organisation?
A
Responsibility for the level of sales, production costs, collection of debts and payment of suppliers
Responsibility for the level of sales, production costs and treasury functions
Responsibility for the level of sales, production costs and purchase of new fixed assets
Responsibility for the level of production costs, treasury functions and collection of debtors and
payment of suppliers
(2 marks)
Sales revenue:
Variable costs
Contribution
Fixed costs
Profit
at 25 per unit
at 20 per unit
at 12 per unit
100,000
(60,000)
40,000
(20,000)
20,000
External
Sales
250,000
(120,000)
130,000
(50,000)
80,000
If Division X does not match the lower price and cannot increase its outside sales and Division Y buys
from the outside supplier, Division X total profit will be
A
B
C
D
65,000
80,000
90,000
100,000
(2 marks)
If Division Y buys from the outside supplier, and Division X cannot increase its external sales, the effect
on Bailey's total profit will be
A
B
C
D
(2 marks)
If Division X reduces its price to Division Y to 18 in order to keep the business, its total profit will be
A
B
C
D
Nil
60,000
80,000
90,000
An increase of 10,000
A decrease of 10,000
A decrease of 30,000
A decrease of 40,000
(2 marks)
One of the main reasons for adopting a decentralised rather than a centralised organisation structure is
the
A
B
C
D
Improved goal congruence between divisional manager and the goals of the organisation
Rapid response of management to environmental changes
Availability of less subjective measures of performance
Improved communication of information among the organisations managers
(2 marks)
280
CHECKPOINT 4
The following data have been extracted from a companys year-end accounts:
7,100,000
4,850,500
3,630,000
4,500,000
2,750,000
950,000
525,000
435,000
Turnover
Gross profit
Operating profit
Non-current assets
Cash at bank
Short term borrowings
Trade receivables
Trade payables
Calculate the following performance measures:
(i)
(ii)
(iii)
(iv)
Current ratio.
(4 marks)
A Division has reported a net profit of 10m for the year ended 30th April 20X9. Included in the calculation
of profit are the following items:
development costs of 12m for a new product that was launched in May 20X8, and is expected to
have a life of four years;
depreciation of 3m
The reported net assets invested in Division L at 30 April 20X9 were 30m. The replacement value of
those assets at that date was 28m.
The actual loss in value of assets during the year was 4m.
The cost of capital for Division L is 5% per year.
Ignore taxation.
Calculate the Economic Value Added for the division for the year ended 30 April 20X9
(3 marks)
10
(2 marks)
Explain the benefits of operating a transfer pricing system within a divisionalised company.
(4 marks)
What are the similarities and differences between EVA and RI?
(4 marks)
(4 marks)
What are the problems associated with transfer pricing in a multinational environment?
(5 marks)
281
CHECKPOINT 4
C
Current ROI =
New ROI =
360
= 22.5%
1,600
(360 + 25)
385
=
= 22.25% which is lower
(1,600 + 130) 1,730
Current ROI
200
= 20%
1000
New ROI
200+22
1000+100
Current RI
Profit
200
(200)
0
222
(220)
2 ... Yes
New RI
= 20.18%
... Yes
An investment centre has responsibility for sales, production and investment in new fixed assets.
130,000
Profit
Lost contribution
= 5,000 2 = 10,000
No of units
sold to Y
70,000
60,000
100,000
(40,000)
60,000
Price
decrease
100,000
current profit
reduction in value
5,000 (20 18)
New profit
(10,000)
90,000
282
CHECKPOINT 4
Or:
Since Bailey can manufacture the product for 12, to buy it in for 18 causes the company to
loose 6.
... overall decrease = 6 5,000 = 30,000
7
10
3
1
3
12
(3)
(4)
22
28
9
1
38
EVA
Economic Profit
Less capital charge: 38 5%
EVA
10
22
(2)
20
283
CHECKPOINT 4
Section B
1
Potential benefits of operating a transfer pricing system within a divisionalised company include the
following.
(a)
(b)
(c)
(d)
It can lead to goal congruence by motivating divisional managers to make decisions, which
improve divisional profit and improve profit of the organisation as a whole.
It can prevent dysfunctional decision making so that decisions taken by a divisional manager
are in the best interests of his own part of the business, other divisions and the organisation as a
whole.
Transfer prices can be set at a level that enables divisional performance to be measured
'commercially'. A transfer pricing system should therefore report a level of divisional profit that is a
reasonable measure of the managerial performance of the division.
It should ensure that divisional autonomy is not undermined. A well-run transfer pricing system
helps to ensure that a balance is kept between divisional autonomy to provide incentives and
motivation, and centralised authority to ensure that the divisions are all working towards the same
target, the benefit of the organisation as a whole.
(a)
The profit figures are calculated differently. EVA is based on an 'economic profit' which is
derived by making a series of adjustments to the accounting profit.
(b)
The notional capital charges use different bases for net assets. The replacement cost of net
assets is usually used in the calculation of EVA.
284
CHECKPOINT 4
(a)
(b)
(c)
(d)
Exchange controls
(e)
Competitive pressures
(f)
Repatriation of funds
285
CHECKPOINT 4
Companies like Analog Devices believe that numbers alone don't tell the whole story. Analog's headquarters
is in a low, sprawling red-brick building about 20 minutes outside Boston. The company's mainstay products are
computer chips for use primarily in communications, military, aviation, and cellular phone applications.
"In the mid-1980s we were not doing well. We simply needed to become more competitive," says Arthur M.
Schneiderman, the MIT-trained engineer who developed the world's first balanced-scorecard model for Analog
when he worked for it back then. "So we surveyed our customers and did benchmarking studies and found that
they cared about things like delivery time and improved quality. Analog then built a model that would help its
managers track and thus better manage such things. "Overall, there were about 15 non financial measures
that we identified as critical to the company's performance," Schneiderman says. These were things like the
rate of on-time deliveries, product development cycle times, number of new products, and so on. Analog
managers can now get a history of how Analog is doing and where it is going overall. They can check on defect
rates plant by plant and see how each plant's quality is improving.
But Analog's model isn't just about the soft stuff. It links measurements like on-time deliveries to certain financial
indicators. For example, the model now measures the percentage of sales due to new-product introductions, and
gross margins on new products. Shell, by contrast, puts greater emphasis on more traditional, corporatewide
indicators like revenues and return on investment.
Once a quarter Analog's 12 senior managers get together for a full day to discuss, among other things, results
from their scorecards. "The managers," says Goodloe Suttler, the company's corporate vice president for
marketing, quality, and planning, "are then asked to explain in front of the group any variances in their results
and what they are going to do about them." One manager, for instance, once had a problem with what it calls its
"new-product ratios." This is a scorecard item that helps managers judge how effectively the company is
spending its R&D dollars. The balanced scorecard showed that one division was lagging in new-product
development. Under the old system this wouldn't have been noticed because all the conventional short-term
financials looked just dandy--i.e., it was too early for the R&D slump to show up in the numbers.
The division manager put more money into R&D and also began to look at new market segments while focusing
a lot of attention on new-product sales and marketing strategies. "We wouldn't have done this if we were just
looking at the financials," Suttler says.
So what does focusing on the soft stuff do for the bottom line? Analog's revenues doubled to $1.2 billion last
year, from $538 million in 1991. Operating profits have increased steadily, from a dismal 3% of sales in 1991 to a
more respectable 19% last year. In April 1993, Analog's stock was selling for some $7 a share. Currently it is
trading at about four times that price, hovering in the $28 range. Not bad for a company that manages itself with
a model that is almost entirely devoid of traditional financial measurements.
Jamie Allsopp, manager of the New Star Hidden Value fund, is just 27 but already handles 44m of savers
money, including at least 1m invested by his boss John Duffield, founder of New Star Asset Management.
Hidden Value has gained 74% since Allsopp took over, compared with 44% for the FTSE All-Share index and
41% for the average fund in the UK All-Companies sector.
In 2004, Hidden Value was ranked second out of 297 funds in the sector, returning 32% compared with 13% for
the All-Share.
As the name of Allsopps fund suggests, he seeks out promising companies that have been missed by the rest of
the market. He uses a system called economic value added, or EVA, to work out if a company is creating value
for shareholders and whether this is reflected in the companys share price.
286
CHECKPOINT 4
He said: EVA analysis is not widely used in the City, but it is a disciplined way of looking at a company and
getting to know the business.
The largest tax dispute in history has been settled between the US Internal Revenue Service (IRS) and
GlaxoSmithKline (GSK), the drugs company, which has agreed to pay the American fiscal authorities $3.1billion
($1.66 billion) in taxes and interest to end a row over transfer pricing.
GSK said that the final payment fell within a $2.2 billion provision made by the company for tax liabilities. The
pharmaceutical giant was exposed to a potential liability of $11.5 billion for 16 years of tax accounts between
1989 and 2005 that were disputed by the IRS. Shares in GSK reacted positively to the settlement yesterday,
gaining 10p to $14.79.
At the core of the dispute was a quarrel between two tax authorities, the IRS and HM Revenue and Customs in
Britain, over how to divide the spoils of Zantac, the blockbuster ulcer treatment that was developed by Glaxo,
GSKs predecessor. The argument between GSK and the IRS was about where the Zantac profit was earned
and how much of the products value should be attributed to each jurisdiction. Developed and manufactured in
the UK but widely sold in America, the US tax bill depended on the transfer price the value at which the drug
was transferred to the groups US marketing subsidiaries.
The zeal with which the IRS has pursued its claim reflects rising tensions between tax authorities as they seek to
capture profits that can move between jurisdictions at the stroke of an accountants pen.
We have consistently said that transfer pricing is one of the most significant challenges for us in corporate tax
administration, Mark Everson, the IRS commissioner, said. The settlement of this case sends a strong message
of our resolve to continue to deal with this issue.
GSK faces further unrelated transfer-pricing litigation in the UK, Japan and Canada, mainly relating to its legacy
Glaxo drugs.
287
CHECKPOINT 4
During a BPP Revision Course you will cover all of the issues above, maximising your chances of picking up
marks. After all, those extra marks could mean the difference between a pass and a fail! We also suggest that if
possible, the final step in your preparation should be a Question Day as an effective exam rehearsal that will test
your technique under timed conditions.
Finally, dont forget that if you wish to make use of our FREE Pass Assurance, then attending a revision course
is one of the criteria you must fulfil.
288
Answers to
Lecture Examples
289
Chapter 1
Answer to Lecture Example 1
120 boxes required
In inventory
50
Need to purchase
70
x resale price
$14
$700
x current
market price
$22
$1,540
15 hrs
5 hrs
Direct labour
(15 hrs @ $6)
Lost contribution 3X
(3 $25)
Relevant cost
90
75
165
Alternative approach
The cash flows which will change if the contract goes ahead are:
$
225
(60)
165
290
Note
(1)
(2)
(3)
(4)
(5)
Aluminium plating
Rivets
Skilled labour
Semi-skilled labour
Overheads
Administration overhead
Total relevant cost
Profit
Minimum price
$
240
50
1,320
1,610
1,610
1,610
(6)
(7)
Notes
(1)
Aluminium is in regular use therefore it needs to be replaced. Value at current purchase price
Relevant cost = 20m2 $12 = 240
(2)
(3)
Skilled labour
Cheaper to work overtime as $24/hr is less than $36/hr (16 + 20)
$
960
360
1,320
40 hrs @ $24 =
10 hrs @ $36
(4)
(spare capacity)
(5)
(6)
Administration costs will be incurred anyway regardless of whether or not the job is accepted
therefore not relevant.
(7)
Profit mark up not relevant as question asks for a minimum price. A minimum price is one which
just covers the total of the relevant costs.
Other factors
Product interdependencies
Inflation
Availability of cash
Time value of money
Impact on supplies
Potential future contracts
Learning curves
Repeat business
Restricted output/capacity
Competition
Recruitment
Technical feasibility
Political, legal and economic considerations
291
Costs to manufacture
$'000
210
15
225
220
15
= $15 each
To breakeven
Relevant contribution = Relevant fixed costs
($54 - $36) units = $23,400
$18 units = $23,400
Units required = 1,300
If Keir were shut down the incremental costs and revenues are as follows.
$'000
Lost revenue
600
Saved
Materials
200
Labour
95
Variable overhead
75
Fixed overhead
40
20% $200
Selling costs
40
Profit foregone
150
Alternatively:
$'000
Fixed costs still incurred
80% $200
Loss forecast
(b)
160
(10)
150
Other factors
292
A
B
10
12
NRV
$
9.25
12.25
Decision
A
B
(b)
(i)
Product A
Product B
Common costs
Net profit
$
25,000
24,000
(47,700)
1,300
2,500 $10
2,000 12
The process is viable if the products are both sold at split off point
(ii)
Product A
Product B
$
32,500
30,000
62,500
(47,700)
(9,375)
(5,500)
(75)
2,500 $13.00
2,000 $15.00
Common costs
Further processing costs product A (2,500 3.75)
product B (2,000 2.75)
Net loss
The process is not viable if both the products are processed further before being sold.
Chapter 2
Answer to Lecture Example 1
Limiting factor is materials as temporary labour can be employed.
Sales
Materials
Labour
(10% premium)
Contribution
Materials (kg)
Contribution/kg
Ranking
293
A
$
150
50
B
$
120
30
C
$
100
15
55
45
55
35
44
41
10
$4.50
$5.83
$13.67
Production plan
Materials
kg
Contract
5A
5B
5C
50
30
15
95
Demand
50 C
50 B
30 A (bal)
150
300
300
845
Chapter 3
Answer to Lecture Example 1
(a)
Let
(b)
Objective:
Maximise
5p + 6h
Subject to
(Leather)
(Skilled labour)
(Quota)
(Non-negativity)
1.5p + 2h 600
0.75p + 0.5h 210
ph0
p, h 0
(c)
294
(d)
P
400
Leather
Number of
purses produced
EU quota
300
280
200
Objective
100
Labour
100
200
(e)
(f)
Contribution = 5p + 6h
= (5 160) + (6 180)
= $1,880 per week
250
160 purses
180 handbags
295
300
400
h
Number of handbags produced
(leather)
(labour)
Optimal solution
h = 178
p = 162.67
Contribution = 5p + 6h = $1,881.33
Original contribution = $1,880.00
Shadow price
1.33
$
1.33
4.20
5.53
Shadow price
Usual price
Maximum price
Chapter 4
Answer to Lecture Example 1
Variable
S1
S1
1.5
S2
0.75
0.5
S3
-1
Solution
-5
-6
S2
S3
600
1
210
1
Soln
Notes:
Each row represents the coefficient of the variables in each of the initial constraints.
The variables in the initial tableau are the unused production (as no products are made).
The solutions indicate shadow prices. They are negative as contribution will be increased once P and H
are produced.
The slacks for constraints 1 and 2 are zero, showing that all available leather or labour will be
used.
The surplus for constraint 3 is 20, indicating that the EU minimum quantity of handbags has been
exceeded by 20, ie. 20 more handbags than purses will be made.
Shadow price/worth:
Constraints 1 and 2 both have zero slack, and so are fully utilised. If more labour or leather could
be obtained, output could be increased, and hence contribution increased.
296
An extra m2 of leather would increase contribution by $2.667, and an extra hour of labour by
$1.333. Constraint 3 is non-zero, and hence a relaxation in the quota would not increase
contribution.
Relative loss:
The relative loss of zero for all products indicates that they are all produced in the optimal
solution.
If a product is not being produced at the optimal point, a relative loss would indicate the reduction
in contribution if one unit of this product had to be manufactured.
(b)
The shadow price for leather is $2.667/m2, indicating that the maximum KG Ltd would be willing to
pay for additional leather is $8 + $2.67 = $10.67/m2.
Hence, it would accept an offer of additional leather at $10.50/m2.
However, it would not want an infinite supply of leather at this price the shadow price in the
computer output is only valid for a range of values.
Chapter 5
Answer to Lecture Example 1
Footballs
$
7
3
4
Selling price
Variable costs
Contribution
Breakeven point
Fixed costs
Average contribution (W1)
20,000
2.889
6,923 units
Baseballs
$
6
4.50
1.50
Rugbyballs
$
9
5
4
2+4+3
$2.889
Football
Baseball
Rugbyball
Sales mix
(a)
Units
2
4
3
9
1,538
3,077
2,308
6,923
297
SP
$
7
6
9
(b)
Revenue
$
10,766
18,462
20,772
50,000
Footballs
Baseballs
Rugbyballs
Costs
(2,000 $3)
(4,000 $4.50)
(3,000 $5)
Fixed costs
Total costs
Revenues
$
6,000
18,000
15,000
39,000
20,000
59,000
$
14,000
24,000
27,000
65,000
(2,000 $7)
(4,000 $6)
(3,000 $9)
Total
costs
50
20
6,923
9,000
Output volume
(units)
Contribution
$
8,000
6,000
12,000
Sales
$
14,000
24,000
27,000
Cumulative sales
$
14,000
41,000
65,000
Cumulative profit
$
(12,000)
0,000
6,000
298
C/S ratio
57.1%
25.0%
44.4%
6,000
X
41,000
0
14,000
X
50,000
65,000
Revenue
12,000
20,000 X
= 3,000 units
Since sales are normally distributed, they can be shown on the following curve:
3,000 3,500
299
3,000 3,500
400
Z = -1.25
This is a probability of 0.3944 (from the tables). We will also break even at sales above 3,500 which has
a probability of 0.5
Probability of breaking even is therefore 0.3944 + 0.5 = 0.8944 or 89.44%
= 3,834 units
( 7 4)
Since sales are normally distributed, they can be shown on the following curve:
3,500 3,834
The Z value for the shaded area is:
Z=
3,834 - 3,500
400
Z = 0.84
Z=
$30,000
(120 30 25)
= 462 units
$30 ,000
(120 31.5 25)
= 473 units
300
(b)
= 62.5% rise
Chapter 6
Answer to Lecture Example 1
(a)
P = a bX
b=
$1
2,500
= 0.0004
12 = a (0.0004 16,000)
a = 18.4
P = 18.4 0.0004X
(b)
MC = MR
5 = 18.4 0.0008X
Therefore, X = 16,750 units
(c)
(d)
MR = 18.4 0.0008X
MR = 0 at maximum revenue
18.4 0.0008X = 0
X = 23,000 units
P = $9.20 per unit
Total Cost
$
10
25
45
70
100
135
MC
$
10
15
20
25
30
35
Selling Price
$
5.00
4.50
4.00
3.50
3.00
2.50
301
Total Revenue
$
50
90
120
140
150
150
MR
$
50
40
30
20
10
0
Profit
$
40
65
75
70
50
15
Chapter 7
Answer to Lecture Example 1
(a)
Output
(b)
100
150
225
337.5
100
75%
75
75%
56.25
75%
42.19
Y = aXb
a = 100
X = 10
b = log 0.75/log 2 = 0.125/0.301 = 0.415
Y
= 100 10 0.415
= 38.459 hrs
Y = aXb
a = 100
X=9
b = 0.415
Y
= 100 9-0415
= 40.1781 hrs
302
Unit
Cumulative Average
Time per unit
20
20
4
8
12.5
12.5
20
r = 0.855 or 86%
(b)
Expected learning rate was 80%. The actual learning rate was therefore slower than expected.
This could be many reasons for this such as:
Changes in the workforce
Demotivated workforce
Break in production between first and the rest of the units
Less skilled staff than anticipated
Too optimistic when setting targets
Introduction
Growth
Maturity
4,000
9,000
30,000
10,000
2,396
4,941
13,470
3,490
24,297
Variable Cost
996
2,241
5,970
1,490
10,697
Overhead
400
900
1,800
750
3,850
500
500
(500)
1,000
1,800
5,700
1,250
9,250
Sales volume
(units)
Decline
Total
$000s
Revenue
Development cost
303
125.00
31.25
93.75
$
Expected cost
Timber
Roofing material (2 17.50)
Wire
Labour (W) (2 7)
Variable overhead (2 1.50)
48.00
35.00
1.50
14.00
3.00
101.50
Cost gap
$7.75
px
1 hours
2 hours
2 hours
0.25
0.5
0.25
0.375
1.0
0.625
px
2.000
Chapter 8
Answer to Lecture Example 1
(a)
Twist
($/m2)
4.53
5.41
9.94
Prime cost
Overheads (W3)
Supertwist
($/m2)
5.43
3.76
9.19
Workings
Activity
Cost pool
Machining
$
5,000,000
Stores
4,750,000
Set-ups
Despatching
5,500,000
3,500,000
Driver
Machine
Hours (W1)
Value of
Materials (W2)
Runs
Customers
Cost driver
units
3,750 : 6,667
10,417
8,100 : 12,960
21,060
400 : 150
15 : 10
550
25
304
Supertwist
20,000 4/12
6,667
Machining
Twist
$
1,800,000
Supertwist
$
3,200,000
Stores
1,830,600
2,928,960
Set ups
4,000,000
1,500,000
Despatching
Total overheads
2,100,000
9,730,600
1,400,000
9,028,960
total m2
O/H per m2
(b)
AC
SP
Cost
Profit
Twist
8.99
8.28
0.71
Supertwist
12.99
10.43
2.56
ABC
SP
Cost
Profit/(loss)
8.99
9.94
(0.95)
12.99
9.19
3.80
305
WhiteyWhite
$
3.00
2.40
0.60
Ordering
0.075
2,250
0.067
Delivery
120
100m3
= $1.20/m3
0.008m3
0.022m3
0.0096
0.0264
Warehousing
480,000
480,000m3
= $1/m3/month
0.008m3 2 months
0.022m3 1.5 months
0.016
0.033
Stores
250,000
200,000m3
= $1.25/m3/month
0.0075
DPP
0.4919
0.0206
0.453
306
Chapter 9a
Answer to Lecture Example 1
20X6
20X7
$'000
Prevention costs
Quality control
Appraisal costs
Inspection of WIP
Internal failure costs
Rework
Scrap
External failure costs
Returns
Complaints
$'000
40
10.1
120
39.3
85
21.6
70
23.0
125
60
46.8
60
20
26.2
35
50
395
21.5
100
15
20
305
11.5
100
Total costs of quality are falling. Also more is being spent on improving conformance. Failure is falling.
However reduced appraisal costs could cause future failures to increase.
A longer period of assessment would be helpful.
Inventory
Cost
Zero defects.
Wastage eliminated.
Inventory
Cost
Lower inventory of
finished goods
Wastage eliminated.
Machines maintained regularly
eliminating breakdowns and slows
in production.
307
H
180
120
Product
Y
315
175
C
180
120
Total
675
415
Inventory
Cost
A
$
140
16
12
27
28
57
3
19
Sales
Materials N
O
P
Labour
Contribution
Kg P
Contribution/kg
Rank
B
$
230
8
27
45
57
93
5
18.6
C
$
280
24
24
90
32
110
10
11
Production plan
P
Kg
600
400
1,000
200 A
80 B
Less: fixed costs
Profit
Contribution
$
11,400
7,440
18,840
8,562
10,278
NB: This treats labour as a variable cost but the reality is labour is fixed and will be paid
regardless of whether demand for all units can be fulfilled.
308
(b)
Throughput
A
$
140
16
12
27
85
3
28.3
Sales
Materials N
O
P
Throughput
Bottleneck resource (Kg P)
Return/KgP
Rank
B
$
230
8
27
45
150
5
30
Production plan
P
Kg
100 B
500
166 A
500
1,000
Less: total factory costs (200*(28 + 17.50)) + (100*(57 +
35.62)) + (75 *(32 + 20))
Profit
(c)
C
$
280
24
24
90
142
10
14.2
Throughput
$
15,000
14,110
29,110
22,262
6,848
Cost/kg P
$
22,262
1,000
$22.26
A
28.3
B
30
C
14.2
22.26
22.26
22.26
1.27
1.35
0.64
Not viable
BR has, effectively, created labour as a fixed cost by guaranteeing a minimum weekly wage.
Throughput accounting regards labour as fixed, in the short-term, and is a better method for
making decisions.
Decisions should now be taken to:
309
Chapter 9b
Answer to Lecture Example 1
COOKING
BUYING
Cheap
Fast
SERVING
Fast/ immediate
Standardised
Fresh
Unique
Product Knowledge
Provenance
Presentation
special
Cheap
airports
New low
maintenance
aircraft
One
class
only
Seat
layouts
Internet
booking
No tickets
No seat
allocations
High quality
Fresh produce
Traceable
provenance
Fairtrade
Wine experts
Carry to car
service
Home
delivery
Quick Check
Price
commitment
quality
food at VFM
Adverts in
quality
magazines
No quibble
replacements
Entertaining
Free glass
hire
By understanding what its customers value Waitrose can maximise the margin they generate.
Focus on quality, freshness, local, British produce, farming standards and sustainability assures its
discerning customers that the produce they are buying is top quality whilst ethically produced.
310
Leisure
passengers
Having instore experts such as wine experts assures the consumer that they will be offered tailored
advice based on their particular requirements.
An appreciation that for many of their customers time is sparse and they dont want to be queuing at
supermarket tills led to developments such as quick check.
Add on services such as Waitrose entertaining enables busy customers to order high quality food for
special occasions.
Removal of inspection of both goods inwards and outwards if quality can be assured and level of
desired quality known a non-value adding activity.
Better knowledge of end customer's interest communicated down the chain. Internet makes this
more feasible.
Has its own farm so can control quality of milk, apples, pears, eggs, mushrooms, free range
chicken etc
Local sourcing within 30 miles enables lower transportation and storage costs
Waitrose Foundation secure long term supply via investment in poorer, volatile countries
Disadvantages
Bad press
Tax
Culture
Due to the naming McLaren Mercedes, McLaren can still sell all the advertising space on the car
311
Mercedes want to be associated with a winning team so they will put a lot of effort into the
development of a high performance engine
PR
Helps their own engine development which they can use in their road cars.
Mercedes engineers will be part of the McLaren team so this requires team working and trust. Mercedes
also supply engines to other teams for a fee, and will often have an engineer with those teams. McLaren
therefore need to trust that Mercedes will not share confidential information about McLaren.
Chapter 10
Answer to Lecture Example 1
Workings:
Materials:
Variable cost = $3/unit
Overhead:
Fixed cost = $20,000
Labour:
Output
14,000
10,000
4,000
(High-low method)
Cost
35,000
27,000
8,000
... VC/unit = $2
By substitution into high output:
Total VC
Total FC
= $28,000
= $35,000 $28,000
= $7,000
Flexed budget
Units
Materials (12,350 3)
Labour (7,000 + 2 12,350)
Overhead
12,350
$
37,050
31,700
20,000
88,750
Actual
Variance
12,350
$
35,000
32,000
23,000
90,000
2,050 F
(300) A
(3,000) A
(1,250) A
If profit centre managers participate in setting the targets they are more likely to accept these and
show more commitment towards achieving them.
312
The detailed knowledge of day to day operations that profit managers have will enable more
effective and relevant targets to be set. This process of information sharing will lead to the
setting of optimal targets, taking into account both organisational and operational constraints and
opportunities and making variance analysis more meaningful.
Research findings confirm that participation increases job satisfaction, improves work related
attitudes and leads to better performance.
The process of participation may be more time consuming in some circumstances participation
may lead to less difficult targets or the introduction of budget slack.
Chapter 11a
Answer to Lecture Example 1
Some examples would include:
Price / rate variance
Favourable this may indicate buying a material / employing labour too cheaply which may have quality
implications.
Adverse a decision to purchase better quality materials may be the right thing to do and lead to better
efficiency.
Usage / efficiency variances
Favourable this may indicate that too little material or time is being used which may result in poor
quality goods.
Sales price variance
Favourable it may be that price has been raised too high so that volume and overall revenue is down.
Adverse this may have been reduced in order to drive more sales.
313
$
504,000
(494,760)
9,240 (F)
$
494,760
513,000
(18,240) (A)
Planning
Should
14,000 units should cost @ 4kg @ $9
Should now 14,000 units @ revised cost @ 3.8kg @ $9.30
Operational
Should now 14,000 units @ revised cost @ 3.8kg @ $9.30
Did
Did cost 54,000 @ $9.50
Planning
Price
Should
14,000 units @ revised std kg should cost @ 3.8kg @ $9
Should now 14,000 units @ revised std kg should now cost @ 3.8kg @ $9.30
Usage
Should
14,000 units @ orig std kg 4kg
Should now 14,000 units @ revised std kg 3.8kg
$
478,800
(494,760)
15,960 (A)
$
56,000
(53,200)
2,800 (F)
$25,200 (F)
$
502,200
(513,000)
10,800 (A)
$
53,200
(54,000)
800 (A)
$7,440 (A)
Price
Should now 54,000 kg should cost @ $9.30
Did
54,000 kg did cost
Usage
Should now 14,000 units @ revised std kg 3.8kg
Did
14,000 units did use
A
B
C
(W)
Std mix
Act qty
26,917 (W)
43,068
16,150
86,135
Act mix
Act qty
27,555
45,905
12,675
86,135
Variance
(638) A
(2,837) A
3,475 F
-
314
Cost/kg
2
5
0.80
Variance
1,276 (A)
14,185 (A)
2,780 (F)
12,681 (A)
Yield variance
Std mix
Std qty
28,125(W)
45,000
16,875
90,000
A
B
C
(W)
Std mix
Act qty
26,917
43,068
16,150
86,135
Variance
1,208 F
1,932 F
725 F
3,865 F
Cost/kg
2
5
0.80
Variance
2,416(F)
9,660 (F)
580 (F)
12,656 (F)
@ 125g =
28,125
@ 200g =
45,000
@ 75g
16,875
Units
215,337.5
225,000
9,662.5 (F)
$12,658 (F)
315
Chapter 11b
Answer to Lecture Example 1
(a)
Gross profit margin =
gross profit
100%
sales
20X9
$
3,269,000
1,503,000
4,772,000
=
=
net profit
Net profit margin =
100%
sales
Net profit margin
=
=
net profit
ROCE =
100%
capital employed
ROCE
=
=
=
=
=
1,503,000
4,772,000
31.5%
20X8
$
2,541,000
1,291,000
3,832,000
1,291,000
3,832,000
33.7%
295,000
4,772,000
6.2%
287,000
3,832,000
7.5%
295,000
3,005,000
9.8%
4,772,000
260
$18,354
287,000
2,861,000
10.0%
3,832,000
248
$15,452
29,361
260
113
27,498
248
111
3,269,000
29,361
111
2,541,000
27,498
92
(b) Big Bonds gross profit has fallen over the period. This implies that either his selling price has fallen,
or his direct costs have risen. An increase in costs is probably the most likely cause. His gross profit
is lower than that of Little Boots.
Net profit has also fallen over the period, this could be a direct flow through from the gross profit,
again this is lower than the competitor. It is however much lower in comparison with Little Boots than
the gross margin is. This would suggest that Little Boots has much better cost control than Big
Bond, not only at a production cost level but also for the non production costs.
As expected given the profitability measures above, ROCE has fallen slightly and is lower than Little
Boots.
Sales per employee has actually risen over the period and is better than Little Boots. Much of the
rise is due to the increase in selling price but not all.
316
Similarly the average number of books produced per employees has increased and is higher than
Little Boots. This implies that Big Bond is being efficient here, getting more from its labour force
than the previous year and its competitor.
The average production cost per book has risen making it more expensive to make than for Little
Boots. Their costs were similar in the previous year. It would seem that it is the direct material cost
that is driving this increase in costs and rendering Big Bond less profitable than Little Boots.
Perhaps Big Bonds suppliers have raised their prices and it would be appropriate to switch to
another supplier.
Big Bonds labour force appear to be very efficient, but Big Bond needs to focus on its direct material
cost control to compete more effectively with Little Boots.
Receivables
243,800
x365 =
x 365
Sales
875,000
Raw materials
96,000
x 365
x 365 =
Purchases
623,000
56.2
Work - in - progress
103,500
x 365 =
x 365
Cost of production
715,000
52.8
Finished goods
75,400
x 365
x 365 =
Cost of sales
743,500
37.0
Trade payables
75,000
x 365 =
x 365
Purchases
623,000
(43.9)
203.8
(b) The competitors cycle is only 156 days. This means that they are managing their operating cycle
much better than KLM and their money is not tied up for as long a period.
KLMs cash is tied up in working capital for nearly 48 days more than their competitors. This could
well be an unhealthy operating cycle. KLM are paying the amounts they owe in just over 40 days but
its taking them just over 100 days to collect their debts. This could result in cash flow problems for
them and certainly is costing them more to fund than their competitors will be paying.
no. of complaints
no. of returning customers
customer satisfaction scores
Internal
staff turnover
time taken to deliver meal to guest
317
Incidents of MRSA
Waiting times
Number of compensations/complaints
Under/over spends against budget
Deaths
Overtime costs
Re-admissions
Costs per bed/night
Number of bed blockers
Length of stay
(b)
(Objective)
Efficiency
Economy
(Cost of inputs)
computers
security
cleaning
Chapter 12
Answer to Lecture Example 1
Possible counter-productive behaviour resulting from using the current ROCE calculation for performance
appraisal
(1)
As managers are judged on the basis of the ROCE that their divisions earn each year, they are
likely to be motivated into taking decisions which increase the division's short-term ROCE and
rejecting projects which reduce the short-term ROCE even if the project is in excess of the
company's target ROCE and hence is desirable from the company's point of view. This is an
example of sub-optimality and a lack of goal congruence in decision making.
(2)
A similar misguided decision would occur if the manager of C division, say, was worried about the
low ROCE of his division and decided to reduce his investment by scrapping some assets not
currently being used. The reduction in both depreciation charge and assets would immediately
improve the ROCE. When the assets were eventually required, however, the manager would
then be obliged to buy new equipment.
(3)
The current method bases the calculation of ROCE on the net book value of assets. If a division
maintains the same annual profits and keeps the same asset without a policy of regular
replacement of non-current assets, its ROCE will increase year by year as the assets get older.
318
Simply by allowing its assets to depreciate a divisional manager is able to give a false impression
of improving performance over time.
The level of new investment in non-current assets by C division was over three times that of B
division in 20X3 and nearly 13 times that of B division in 20X4. B division is using old assets that
have been depreciated to a much greater extent than those of C division and hence the basis of
the ROCE calculation is much lower. Consequently it is able to report a much higher ROCE.
(4)
The method used to calculate ROCE therefore also provides a disincentive to divisional mangers
to reinvest in new or replacement assets because the division's ROCE would probably fall.
(5)
A further disadvantage of measuring ROCE as profit divided by the net book value of assets is
that it is not easy to compare fairly the performance of one division with another. Two divisions
might have the same amount of working capital, the same value of non-current assets at cost and
the same profit. But if one division's assets have been depreciated by a much bigger amount,
perhaps because they are older, that division's ROCE will be bigger.
In some respects this is the case with B and C divisions. Both the profit and the original asset cost
of C division are about the same proportion of B division's profit and original asset cost but the
ROCE of B division is twice that of C division.
(b)
Vittorio:
Current ROI =
90,000
= 18%
500,000
ROI of equipment =
1,200
= 15%
8,000
60,00020,0005,000
ROI of replacement =
2 ,000
= 1750%
60,00015,000
= 60%
75,000
=
=
1,200
(960)
240 (Positive so accept)
Dugaldo:
=
=
319
45,000
35,000
10,000
(9,000)
$1,000 (Positive so accept)
$
18,500
8,100
(12,300)
6,000
(2,000)
18,300
98,000
19,000
4,000
121,000
NOPAT
Capital charge (11% $121,000)
EVA
18,300
13,310
4,990
Adjustment to operating profit removes the differences that accounting policies may create no
gain from manipulating profit.
Prevents short-term decisions being taken as expenditure (ie advertising) spread over the period
that benefits from it.
EVA focuses on maximising shareholder wealth incentivising achievement of EVA will drive
shareholder value.
where the imputed interest = weighted average cost of capital net assets
The calculation of EVA is very similar to the calculation of RI.
EVA = net operating profit after tax (NOPAT) less capital charge
where the capital charge = weighted average cost of capital net assets
EVA and RI are similar because both result in an absolute figure which is calculated by subtracting an
imputed interest charge from the profit earned by the investment centre. However there are differences as
follows.
(a)
The profit figures are calculated differently. EVA is based on an 'economic profit' which is
derived by making a series of adjustments to the accounting profit.
(i)
Costs which would normally be treated as expenses, but which are considered within an
EVA calculation as investments building for the future, are added back to NOPAT to derive
a figure for 'economic profit'. These costs are included instead as assets in the figure for
net assets employed, ie as investments for the future. Costs treated in this way include
items such as goodwill, research and development expenditure and advertising
costs.
(ii)
Accounting depreciation is added back to the profit figures, and economic depreciation is
subtracted instead to arrive at NOPAT. Economic depreciation is a charge for the fall in
asset value due to wear and tear or obsolescence.
320
(iii)
(b)
Any lease charges are excluded from NOPAT and added in as a part of capital employed.
The notional capital charges use different bases for net assets. The replacement cost of net
assets is usually used in the calculation of EVA.
Chapter 13
Answer to Lecture Example 1
There is no incentive for the receiving division to buy internally. If they can they will buy externally at $26.
This may be sub optimal from the groups perspective.
Units
2,400
1,250
1,325
hours
7,200
7,500
5,300
20,000
If labour is diverted for the transfer, hours will come from product Eee which is earning contribution of $16
per hour.
Minimum transfer price should be:
Variable unit cost
Opportunity cost 6 hrs x $16
Therefore minimum transfer price is
$
95
96
191
$
200
240
$200
321
Division 1
$
550,000
189,000
739,000
(480,000)
(150,000)
109,000
14.7%
12.1%
Division 2
$
690,000
(240,000)
(189,000)
(150,000)
111,000
16.1%
13.1%
$
45
18
63
$60 75%
40% mark-up
(b)
Division 1
$
550,000
225,000
775,000
(480,000)
(150,000)
145,000
18.7%
16.1%
Division 2
$
690,000
(240,000)
(225,000)
(150,000)
75,000
10.9%
8.8%
322
$60 1.25
Div1
Current
New transfer
transfer price price
109,000
145,000
19.8%
26.4%
12.1%
16.1%
Profit
Profit Margin
ROI
Current
transfer price
111,000
16.1%
13.1%
Div2
New transfer
price
75,000
10.9%
8.8%
Changing the transfer price takes the transfer price from $63 to $75 per unit.
For all the performance measures this improves the performance shown by division 1 but division
2s measures deteriorate.
Division 1 would therefore be very happy with the new level of transfer price.
With the current transfer price the groups desired ROI is achieved by both divisions. Changing
the transfer price to $75 means that division 2 no longer meets the groups target ROI. Division 2
are therefore likely to be demotivated if the transfer price was changed.
As a result Division 2 are unlikely to accept $75 as a transfer price. They may look to source an
alternative for the Woody from suppliers outside AJH.
Transfer
1
2
3
4
5
MCs
30
40
50
60
70
Receiving
MCr
60
65
70
75
80
TR
125
240
345
440
525
MRr
125
115
105
95
85
NMRr
65
50
35
20
5
NMRr
65
50
35
20
5
Division S profit will be reduced to zero, so the manager of division S will be demotivated
(assuming performance evaluation is based on profit).
(b)
R
800
(40)
760
(1,100 300)
(5% 800)
323
324
Question and
Answer bank
325
Answers
326
1 Z Ltd
Z Ltd manufactures three joint products (M, N and P) from the same common process. The following
process account relates to the common process last month and is typical of the monthly results of
operating this process:
Litres
1,000
100,000
Litres
10,000
25,000
15,000
45,000
800
$
20,000
141,875
85,125
255,375
3,533
5,200
101,000
29,412
535,320
Each one of the products can be sold immediately after the common process, but each one of them can be
further processed individually before being sold. The following further processing costs and selling prices
per litre are expected:
Selling price after
Selling price after
Further variable
Product
common process
further processing
processing cost
$/litre
$/litre
$/litre
M
6.25
8.40
1.75
N
5.20
6.45
0.95
P
6.80
7.45
0.85
Required
(a)
State the method used to apportion the common costs between the products M, N and P and
comment on its acceptability. Explain why it is necessary to apportion the common costs between
each of the products.
(5 marks)
(b)
Evaluate the viability of the common process, and determine the optimal processing plan for each
of the three products, showing appropriate calculations.
(5 marks)
(Total = 10 marks)
327
2 Exe
You have received a request from EXE to provide a quotation for the manufacture of a specialised piece of
equipment. This would be a one-off order, in excess of normal budgeted production. The following cost
estimate has already been prepared:
Note
Direct materials:
Steel
Brass fittings
Direct labour:
Skilled
Semi-skilled
Overhead
Estimating time
1
2
50
20
3
4
5
6
200
50
350
100
770
154
924
231
1,155
Notes
1
2
3
4
5
6
7
8
The steel is regularly used, and has a current stock value of $5.00 per square metre. There are
currently 100 square metres in stock. The steel is readily available at a price of $5.50 per square
metre.
The brass fittings would have to be bought specifically for this job: a supplier has quoted the price
of $20 for the fittings required.
The skilled labour is currently employed by your company and paid at a rate of $8.00 per hour. If
this job were undertaken it would be necessary either to work 25 hours' overtime, which would be
paid at time plus one half, OR in order to carry out the work in normal time, reduce production of
another product that earns a contribution of $13.00 per hour.
The semi-skilled labour currently has sufficient paid idle time to be able to complete this work.
The overhead absorption rate includes power costs which are directly related to machine usage. If this
job were undertaken, it is estimated that the machine time required would be ten hours. The
machines incur power costs of $0.75 per hour. There are no other overhead costs that can be
specifically identified with this job.
The cost of the estimating time is that attributed to the four hours taken by the engineers to analyse
the drawings and determine the cost estimate given above.
It is company policy to add 20% to the production cost as an allowance for administration costs
associated with the jobs accepted.
This is the standard profit added by your company as part of its pricing policy.
Required
Prepare on a relevant cost basis, the lowest cost estimate that could be used as the basis for a quotation.
Explain briefly your reasons for using each of the values in your estimate.
(10 marks)
328
3 KL Retail Outlet
A retail company has a number of individual retail outlets in different towns. Each outlet has its own
manager who can make decisions about the individual retail outlet, provided these decisions are within the
parameters of the overall company policy. The performance of each individual manager is measured
based on the profits of the retail outlet that he or she manages.
Company policy
It is company policy that each of the retail outlets should stock the following categories of items for sale to
customers:
Company policy also requires that no single category should occupy more than 40% or less than 15% of
the total display space available. In addition, at their own discretion, managers are permitted to use up to
10% of the total display space available for other products that meet other localised needs.
The KL Retail Outlet
The following weekly sales and cost data relate to the KL retail outlet, one of the outlets owned by the
company:
Sales
Purchase costs
Display space
$'000
$'000
%
Newspapers and magazines
150
105
25
Fresh fruit and vegetables
130
75
20
Tinned food items
400
240
30
Frozen food items
200
90
15
Other products
150
100
10
The total display space available is 800 square metres.
For each category of items for sale:
In addition to the purchase costs of the items sold the retail outlet incurs other costs that total $280,000
per week.
Required
Demonstrate, using the above information and appropriate calculations, how the manager of the KL retail
outlet should allocate the space available between the different categories of items for sale to customers in
order to maximise his weekly profit.
(7 marks)
329
4 Linear Programming
Company C manufactures two products. The budgeted selling price and cost per unit are as follows:
Product
Selling price
Direct labour ($8 per hour)
Direct material A ($3 per kg)
Direct material B ($4 per kg)
Other variable costs
Fixed overhead absorbed
Profit
X
$/unit
86
16
12
12
20
12
14
Y
$/unit
74
12
15
8
15
12
12
Demand for the products is seasonal. In order to ensure that the production facilities are not idle at various
times during the year the company has signed a contract with company D to supply them with the
products as own label goods.
Company D Contract
The company is to supply Company D with 500 units of product X and 300 units of product Y in each of
November and December 2009 for $73 and $62 per unit respectively. If Company C fails to honour this
contract in full in each of these months then there is a significant financial penalty for each month of their
failure.
November 2009
The total number of direct labour hours available to produce products X and Y in November 2009 is
limited to 4,000 hours, but all of the other production resources are readily available in November 2009.
In addition to the contract with Company D, the demand for products X and Y in November 2009 is
1,000 units and 800 units respectively.
December 2009
In December there will be 5,450 direct labour hours available to produce products X and Y and the supply
of materials will also be limited. Only 11,000 kgs of material A and 6,100 kgs of material B will be
available.
In addition to the contract with Company D, the demand for products X and Y in December 2009 is
1,300 units and 1,400 units respectively.
Inventory
Company C does not hold inventories of materials or finished goods.
Required:
(a)
Prepare calculations to determine the production plan that will maximise the profits of Company C
in November 2009.
(5 marks)
(b)
Use graphical linear programming to calculate the optimal production plan for the month.
(10 marks)
(ii)
Calculate the value of the monthly financial penalty at which the company would be
indifferent between supplying products X and Y under the Company D contract or selling
them in the general market.
(5 marks)
(iii)
Calculate the maximum price per kg that should be paid to an alternative supplier to obtain
additional material B.
(5 marks)
(Total = 25 marks)
330
5 Simplex
A company manufactures three products and is planning the use of its resources for the next quarter.
Details of the products and their resource requirements are as follows:
Product
Contribution per unit
Material A per unit (S1)
Material B per unit (S2)
Labour per unit (S3)
Q
$36
5 kgs
6 litres
4 hours
R
$38
6 kgs
3 litres
5 hours
T
$44
4 kgs
8 litres
6 hours
All of these resources are limited in supply. The total available resources for the next quarter are:
Material A (S1)
Material B (S2)
Labour (S3)
4,800 kgs
5,000 litres
3,500 hours
Required
Prepare the initial equations for S1, S2 and S3 to be used in solving this problem using linear
programming
(3 marks)
6 Optimal Pricing
A company is considering the price of one of its products for next year. It expects that the variable cost of
making the item will be $15 per unit. It has also determined that if the selling price were to be $35 per
unit then the demand would be 500 units per week.
However, for every $5 increase in selling price, there would be a reduction in demand of 50 units per
week; and for every $5 reduction in selling price, there would be an increase in demand of 50 units per
week.
Required
Calculate the optimal selling price.
Note: If Price P = a-bx then Marginal Revenue = a-2bx
331
(4 marks)
7 Learning Curves 2
A company has developed a new product that it will manufacture in its workshop. The product is highly
specialised and initially will be produced to order only. The product will be manufactured in batches. The
estimated labour time required for the first batch is 40 hours, but due to the nature of the product and the
manufacturing method to be used, it is expected that an 80% learning curve will apply.
Required
(3 marks)
(a)
(b)
When production commenced the first batch took 45 hours. The actual learning rates observed
were as follows.
Total batches produced
Month
to date
Actual learning rate
1
1
2
2
75%
3
4
75%
4
8
90%
For each of months 2 and 4, state possible reasons why the actual learning rates differed from the
expected rates.
(3 marks)
(c)
The total time taken to produce the first eight batches was 182.25 hours. Calculate the cumulative
learning rate up to the end of Month 4. (Remember that the first batch took 45 hours.) (4 marks)
(Total = 10 marks)
8 KL
KL manufactures three products, W, X and Y. Each product uses the same materials and the same type of
direct labour but in different quantities. The company currently uses a cost plus basis to determine the
selling price of its products. This is based on full cost using an overhead absorption rate per direct labour
hour. However, the managing director is concerned that the company may be losing sales because of its
approach to setting prices. He thinks that a marginal costing approach may be more appropriate,
particularly since the workforce is guaranteed a minimum weekly wage and has a three month notice
period.
Required
(a)
Given the managing directors concern about KLs approach to setting selling prices, discuss the
advantages and disadvantages of marginal cost plus pricing AND total cost plus pricing. (6 marks)
The direct costs of the three products are shown below:
Product
Budgeted annual production (units)
Direct materials
Direct labour ($10 per hour)
W
15,000
X
24,000
Y
20,000
$ per unit
35
40
$ per unit
45
30
$ per unit
30
50
In addition to the above direct costs, KL incurs annual indirect production costs of $1,044,000.
332
Required
(b)
Calculate the full cost per unit of each product using KLs current method of absorption costing.
(4 marks)
An analysis of the companys indirect production costs shows the following:
$
220,000
100,000
400,000
324,000
Cost driver
Number of supplier orders
Number of batches
Number of machine hours
Number of machine hours
W
5
500
4
8
400
3
7
1,000
5
Required
(8 marks)
(c)
Calculate the full cost per unit of each product using activity based costing
(d)
Explain how activity based costing could provide information that would be relevant to the
management team when it is making decisions about how to improve KLs profitability. (7 marks)
(Total = 25 marks)
and explains the relationship between Compliance and Non-compliance costs in the context of
Total Quality Management.
(10 marks)
333
10 M plc
M plc designs, manufactures and assembles furniture. The furniture is for home use and therefore varies
considerably in size, complexity and value. One of the departments in the company is the assembly
department. This department is labour intensive; the workers travel to various locations to assemble and fit
the furniture using the packs of finished timbers that have been sent to them.
Budgets are set centrally and they are then given to the managers of the various departments who then
have the responsibility of achieving their respective targets. Actual costs are compared against the budgets
and the managers are then asked to comment on the budgetary control statement. The statement for April
for the assembly Department is shown below.
Assembly labour hours
Assembly labour
Furniture packs
Other materials
Overheads
Total
Budget
6,400
$
51,970
224,000
23,040
62,060
361,070
Actual
7,140
Variance
$
58,227
205,000
24,100
112,340
399,667
$
6,257 Adverse
19,000 Favourable
1,060 Adverse
50,280 Adverse
38,597 Adverse
Note. The costs shown are for assembling and fitting the furniture (they do not include time spent
travelling to jobs and the related costs). The hours worked by the manager are not included in the figure
given for the assembly labour hours.
The manager of the assembly department is new to the job and has very little previous experience of
working with budgets but he does have many years experience as a supervisor in assembly departments.
Based on that experience he was sure that the department had performed well. He has asked for your help
in replying to a memo he has just received asking him to 'explain the serious overspending in his
department'. He has sent you some additional information about the budget:
(1)
The budgeted and actual assembly labour costs include the fixed salary of $2,050 for the manager
of the assembly department. All of the other labour is paid for the hours they work.
(2)
The cost of furniture packs and other materials is assumed by the central finance office of M plc to
vary in proportion to the number of assembly labour hours worked.
(3)
The budgeted overhead costs are made up of three elements: a fixed cost of $9,000 for services
from central headquarters, a stepped fixed cost which changes when the assembly hours exceed
7,000 hours, and some variable overheads. The variable overheads are assumed to vary in
proportion to the number of assembly labour hours. Working papers for the budget showed the
impact on the overhead costs of differing amounts of assembly labour hours:
Assembly labour hours
Overhead costs
5,000
$54,500
7,500
$76,500
10,000
$90,000
Prepare, using the additional information that the manager of the assembly department has given
you, a budgetary control statement that would be more helpful to him.
(9 marks)
(b)
Discuss the differences between the format of the statement that you have produced and that
supplied by M plc.
(3 marks)
Discuss whether M plc should change to a system of participative budgeting.
(8 marks)
(c)
(d)
Outline the difference between budgets for planning and budgets for control, citing an example of
each.
(5 marks)
(Total = 25 marks)
334
11
Mills Ltd
Mills Ltd make units, which are sold directly to the public. The new production manager has argued that
the business should use a higher quality material.. The materials are more expensive but should produce
an improved product. It was hoped that this would stimulate demand and enable an immediate price
increase for the units.
Mills Ltd operates a responsibility based standard costing system which allocates variances to specific
individuals. The individual managers are paid a bonus only when net favourable variances are allocated to
them.
The new higher quality production approach was adopted at the start of March 20X9, following a decision
by the new production manager. No change was made at that time to the standard costs card. The
variance reports for February and March are shown below (Fav = Favourable and Adv = Adverse)
Manager responsible
Allocated variances
Production manager
Sales manager
Sales price
Sales contribution volume
February
Variance
$
25 Fav
0
20 Fav
March
Variance
$
2,100 Adv
600 Adv
400 Fav
40 Adv
35 Adv
7,000 Fav
3,000 Fav
The production manager is upset that he seems to have lost all hope of a bonus under the new system.
The sales manager thinks the new high quality units are excellent and is very pleased with the progress
made.
Mills Ltd operate a JIT stock system and holds virtually no inventory.
Required
(a)
Assess the performance of the production manager and the sales manager and indicate whether the
current bonus scheme is fair to those concerned.
(7 marks)
335
Kg
010
012 per kg
010
010
010
040
070 per kg
170 per kg
050 per kg
085
035
The budget for production and sales in April was 50,000 units. Actual production and sales was 60,000
units in the month, during which the following occurred:
Kg
Materials used
A1
B2
C3
D4
Total input
Actual loss
Actual output of units mixture
Actual sales price of a units
5,700
6,600
6,600
4,578
23,478
(1,878)
21,600
$741
$5,610
$11,880
$2,747
$20,978
$099
Required
(b)
Calculate the material price, mix and yield variances and the sales price and sales contribution
volume variances for April. You are not required to make any comment on the performance of the
managers.
(13 marks)
(Total = 20 marks)
12
Silk Imports
Silk imports is a new business, selling high quality imported women's scarves via the internet. The
managers, who also own the company, are young and inexperienced but they are prepared to take risks.
They are confident that importing quality scarves and selling via a website will be successful and that the
business will grow quickly. This is despite the well recognised fact that selling clothing is a very
competitive business.
They were prepared for a loss-making start and decided to pay themselves modest salaries (included in
administration expenses in Table 1 below) and pay no dividends for the foreseeable future.
The owners are so convinced that growth will quickly follow that they have invested enough money in
website server development to ensure that the server can handle the very high levels of predicted growth.
All website development costs were written off as incurred in the internal management accounts that are
shown below in Table 1.
Significant expenditure on marketing was incurred in the first two quarters to launch both the website and
new products. It is not expected that marketing expenditure will continue to be as high in the future.
Customers can buy a variety of styles, patterns and colours of scarves at different prices.
336
The business's trading results for the first two quarters of trade are shown below in Table 1.
Table 1
Quarter 1
$
Sales
less Cost of Sales
Gross Profit
less expenses
Website development
Administration
Distribution
Launch marketing
Other variable expenses
Total expenses
Loss for quarter
$
420,000
(201,600)
218,400
120,000
100,500
20,763
60,000
50,000
Quarter 2
$
$
680,000
(340,680)
339,320
90,000
150,640
33,320
40,800
80,000
(351,263)
(132,863)
(394,760)
(55,440)
Required
(a)
Assess the financial performance of the business during its first two quarters using only the data in
Table 1 above.
(12 marks)
The owners are well aware of the importance of non-financial indicators of success and therefore have
identified a small number of measures to focus on. These are measured monthly and then combined to
produce a quarterly management report.
The data for the first two quarters management reports is shown below:
Table 2
Quarter 1
27,631
95%
12%
2%
Quarter 2
38,857
89%
18%
4%
Comment on each of the non-financial data in Table 2 above taking into account, where
appropriate, the industry averages provided, providing your assessment of the performance of the
business.
(8 marks)
(Total = 20 marks)
13 Y and Z plc
(a)
A large organisation, with a well-developed cost centre system, is considering the introduction of
profit centres and/or investment centres throughout the organisation, where appropriate. As
management accountant, you will be providing technical advice and assistance for the proposed
scheme.
Required
Explain what conditions are necessary for the successful introduction of profit centres and
investment centres.
337
(5 marks)
(b)
Y and Z are two divisions of a large company that operate in similar markets. The divisions are
treated as investment centres and every month they each prepare an operating statement to be
submitted to the parent company. Operating statements for these two divisions for October are
shown below:
Operating statements for October
Sales revenue
Less variable costs
Contribution
Less controllable fixed costs (includes depreciation on
divisional assets)
Controllable income
Less apportioned central costs
Net income before tax
Total divisional net assets
Y
'000
900
345
555
95
Z
'000
555
312
243
42
460
338
122
9.76m
201
180
21
1.26m
The company currently has a target return on capital of 12% per annum. However, the company
believes its cost of capital is likely to rise and is considering increasing the target return on capital.
At present the performance of each division and the divisional management are assessed primarily
on the basis of return on investment (ROI).
Required
(i)
Calculate the annualised return on investment (ROI) for divisions Y and Z, and discuss the
relative performance of the two divisions using the ROI data and other information given
above.
(9 marks)
(ii)
Calculate the annualised residual income (RI) for divisions Y and Z, and explain the
implications of this information for the evaluation of the divisions' performance.
(6 marks)
(iii)
Briefly discuss the strengths and weaknesses of ROI and RI as methods of assessing the
performance of divisions. Explain two further methods of assessment of divisional
performance that could be used in addition to ROI or RI.
(5 marks)
(Total = 25 marks)
14 FP Photocopiers
FP sells and repairs photocopiers. The company has operated for many years with two departments, the
Sales Department and the Service Department, but the departments had no autonomy. The company is
now thinking of restructuring so that the two departments will become profit centres.
The Sales Department
This department sells new photocopiers. The department sells 2,000 copiers per year. Included in the
selling price is 60 for a one year guarantee. All customers pay this fee. This means that during the first
year of ownership if the photocopier needs to be repaired then the repair costs are not charged to the
customer. On average 500 photocopiers per year need to be repaired under the guarantee. The repair work
is carried out by the Service Department who, under the proposed changes, would charge the Sales
Department for doing the repairs. It is estimated that on average the repairs will take 3 hours each and
that the charge by the Service Department will be 136,500 for the 500 repairs.
The Service Department Adverse
This department has two sources of work: the work needed to satisfy the guarantees for the Sales
Department and repair work for external customers. Customers are charged at full cost plus 40%. The
details of the budget for the next year for the Service Department revealed standard costs of:
Parts
Labour
Variable overheads
at cost
15 per hour
10 per labour hour
338
Fixed overheads
The calculation of these standards is based on the estimated maximum market demand and includes the
expected 500 repairs for the Sales Department. The average cost of the parts needed for a repair is 54.
This means that the charge to the Sales Department for the repair work, including the 40% mark-up, will
be 136,500.
Proposed Change
It has now been suggested that FP should be structured so that the two departments become profit
centres and that the managers of the Departments are given autonomy. The individual salaries of the
managers would be linked to the profits of their respective departments.
Budgets have been produced for each department on the assumption that the Service Department will
repair 500 photocopiers for the Sales Department and that the transfer price for this work will be
calculated in the same way as the price charged to external customers.
However the manager of the Sales Department has now stated that he intends to have the repairs done by
another company, RS, because they have offered to carry out the work for a fixed fee of 180 per repair
and this is less than the price that the Sales Department would charge.
Required
(a)
(b)
(c)
(d)
Calculate the individual profits of the Sales Department and the Service Department, and of FP as a
whole from the guarantee scheme if:
(i)
(ii)
(iii)
The repairs are carried out by the Service Department and are charged at full cost plus 40%;
The repairs are carried out by the Service department and are charged at marginal cost;
The repairs are carried out by RS.
(7 marks)
(i)
Explain, with reasons, why a full cost plus transfer pricing model may not be appropriate
for FP.
(2 marks)
(ii)
Comment on other issues that the managers of FP should consider if they decide to allow RS
to carry out the repairs.
(3 marks)
Briefly explain the advantages and disadvantages of structuring the departments as profit centres.
(4 marks)
SW Limited and AL Limited are members of the same group. SW Limited supplies its output to AL
Limited, as well as selling to its external market.
SW Limited has capacity to produce up to 500,000 litres a week. The external market demand is
350,000 litres per week, and previously AL Limited demanded 100,000 litres per week. AL
Limited has now advised SW Limited that it will require 250,000 litres per week from January
20X2.
SWAL group policy
Evaluate the performance of group companies on the basis of their individual profits
Set transfer prices that will encourage the maximisation of group profits
Required
Prepare a report to the group management team outlining how an appropriate transfer pricing
policy would provide a satisfactory basis for appraising the performance of individual companies.
Comment on the implications of this policy for the maximisation of group profits.
(9 marks)
(Total = 25 marks)
339
15
PCs R Us
PCs R Us is a company that manufactures and sells PCs. It has two divisions.
Division P makes the components that go into each PC. Division C assembles the PCs to each individual
customers requirements and ships them to the customer.
The components Division P makes are only transferred to C. Division C only uses components that P has
produced but also incurs additional costs in assembling and distributing orders to customers.
Currently profit is used to assess each divisions performance. The transfers that take place do so at full
cost plus.
Required
(a)
(b)
Discuss the possible behavioural consequences that may arise as a result of the current
performance evaluation methods.
(5 marks)
Suggest with reasons an appropriate transfer pricing policy for PCs R Us.
(5 marks)
(Total = 10 marks)
340
1 Z Ltd
(a)
Product
M
N
P
Litres (ii)
25,000
15,000
45,000
85,000
As $482,375/85,000 = $5.675 the method used to apportion common costs between the joint
products is litres produced.
This method is only suitable when products remain in the same state that is dont separate into
liquid and gas products. It also doesn't take into account the relative income earning potential of each
product.
However, it does allow values to be put on the products for stock and financial reporting purposes.
It is necessary to apportion the common costs between each product to put a value on stock for
financial reporting and so sales can be matched with the cost the of sales.
(b)
(i)
Litres
25,000
15,000
45,000
Total revenue
$
156,250
78,000
306,000
540,250
(482,375)
57,875
M
N
P
Selling price
now
$
6.25
5.20
6.80
Selling price
after
$
8.40
6.45
7.45
Extra variable
costs
$
1.75
0.95
0.85
Contribution
$
6.65
5.50
6.60
Products M and N should be processed further as the contribution per unit of each of these
products is greater than the selling price before extra processing takes place (net revenue is
positive). Product P should not be processed further as Z Ltd would be worse off by ($6.80
$6.60) = $0.20 per unit.
341
2 Exe
$
Notes
Direct materials
Steel
Brass fittings
Direct labour
Skilled
Semi-skilled
Overhead
Estimating time
Administration overhead
Profit
Selling price
55.00
20.00
2
3
4
5
300.00
7.50
382.50
382.50
6
7
There is no incremental cost involved since the employees are currently being paid to be idle.
General fixed costs will be incurred regardless of whether or not the order is accepted and so are
not relevant. The relevant cost therefore relates to the machine usage and is 10 hrs $0.75.
Administration costs will be incurred regardless of whether or not the order is accepted and so are
not relevant.
We are asked to produce a lowest cost estimate which is one which just covers incremental costs
and makes no profit. The profit mark up is therefore not relevant.
3 KL Retail Outlet
Limiting factor is display space available therefore space should be allocated according to contribution per
square metre of display space (subject to company policy constraints).
Category
Display space
Total
Contribution
Contribution
per m2
Ranking
m2
$'000
Newspapers/magazines
200
45
225
160
55
344
240
160
667
120
110
917
Other products
80
50
625
Company policy requires each of the four main categories to be allocated at least 15% of floor space. This
leaves up to 40% of floor space free to be allocated according to the rankings above.
Floor area allocated to frozen food items should be maximised (that is, 40% of total area). After
minimum floor space (15%) has been allocated to the other three main categories, this leaves 15% to be
342
allocated to the tinned food items which were ranked second (therefore this category will receive 30% of
the total floor area).
The final allocation will be
Floor space
Total profit
m2
$000
Newspapers/magazines
120
27.00
($225 120)
120
41.28
($344 120)
240
160.08
($667 240)
320
293.44
($917 320)
800
521.80
Category
(280.00)
241.80
4 Linear Programming
(a)
Contribution
Direct labour hours/unit
Contribution per direct labour
hour
Rank
Minimum
Uses
Balance
Total production
(b)
X
$/unit
26
2
13
Y
$/unit
24
15
16
2
500 units
1,000 hours
675 units
1,350 hours
1,175 units
1
300 units
450 hours
800 units
1,200 hours
1,100 units
1,450 hours
2,550 hours
Firstly, the resources available after meeting the minimum contract must be calculated. Then
inequalities / equations can be calculated and plotted to determine the optimal use of the remaining
resources:
Resource
DL
A
B
Used by contract
X
Y
Total
1,000
450
1,450
2,000
1,500
3,500
1,500
600
2,100
Unused
4,000
7,500
4,000
Equation
2x + 1.5y = 4,000
4x + 5y = 7,500
3x + 2y = 4,000
Data points
x
y
2,000 2,667
1,875 1,500
1,333 2,000
In addition to the above resource constraints, there are two demand constraints:
x = 1,300
y = 1,400
and an iso-contribution line:
Z = 26x + 24y (using $20,000 as a target contribution) give data points of x = 769 and y = 833
343
344
(i)
The optimal production plan is 725 units of X and 925 units of Y plus fulfilment of the contract.
(ii)
If the contract were not to be performed then the resources used by the contract would be used to
make additional units of X and Y for sale in the external market.
The graph shows that the two material resources are more binding than the direct labour constraint
so the optimal use of the resources released can be calculated:
4x + 5y = 3,500 becomes 12x + 15y = 10,500
3x + 2y = 2,100 becomes 12x + 8y = 8,400
Therefore 7y = 2100 so y = 300 and by substitution x = (3,500 (5 x 300))/4 = 500. This is
the same as the resource utilisation for the contract, so revenues can be compared.
All of the production capacity can be sold in the open market at the full selling prices, so if the
penalty value were equal to the loss of sales revenue, the company would be indifferent between
the contract and market sales. This amounts to:
500 Units of X at $13 per unit plus 300 units of Y at $12 per unit = $10,100
(iii)
Both material constraints are binding. If material B were less scarce then the output would change:
Existing position
4x + 5y = 7,500 becomes 12x + 15y = 22,500
3x + 2y = 4,000 becomes 12x + 8y = 16,000
Therefore 7y = 6,500 so y = 92857 and by substitution x = (7,500 (5 x 92857))/4 =
71429
Revised position
4x + 5y = 7,500 becomes 12x + 15y = 22,500
3x + 2y = 4,001 becomes 12x + 8y = 16,004
Therefore 7y = 6,496 so y = 928 and by substitution x = (7,500 (5 x 928))/4 = 715
Thus
There is a reduction in y by 057 units losing $1368 contribution
There is an increase in x by 071 units gaining $1846 contribution
The net effect therefore is an increase in contribution of $478 so the maximum price that should
be paid per kg is $878 (the original cost per kg plus the contribution value).
5 Simplex
q = number of units of Q,
r = number of units of R and
t = number of units of T.
S1 is slack material A,
S2 is slack material B,
S3 is slack labour
5q + 6r + 4t + S1 = 4,800
6q + 3r + 8t + S2 = 5,000
4q + 5r + 6t +S3 = 3,500
6 Optimal Pricing
Demand function = P = a bx
b = 5/50 = 0.1
35 = a (500 x 0.1)
35 = a 50
a = 85
Demand function is therefore: P = 85 0.1x
Maximise profit when MR = MC
345
= a 2bx
= 85 (2 0.1x)
= 0.2x
= 350 units
7 Learning Curves 2
(a)
= aXb
Y8
= 40 8-0.32193
= 40 0.512
= 20.48 hours (average time per batch)
Y7
= 40 7-0.32193
= 40 0.534
= 21.36 hours (average time per batch)
Cumulative batches
8
7
Total time
(hours)
163.84
149.52
14.32
The expected time for the eighth batch is therefore 14.32 hours
(b)
Possible reasons why actual learning rates differed from expected rules
The learning rates for months 2 and 3 are better than expected. This may be due to management
underestimating the ability of the workforce to master the new techniques. The workforce may also
have been initially enthusiastic about learning new skills.
The learning rate in month 4 deteriorated. Possible reasons for this could be changes in the
workforce, lack of motivation or potential long periods between production of batches (as batches
are only produced to order).
(c)
22.78
45
182.25
8
= 22.78 hours
= 0.506
r3 = 0.506
r=
0.506
346
8 KL
(a)
It fails to recognise that since demand may be determining price, there will be a profitmaximising combination of price and demand.
(ii)
(iii)
Budgeted output volume needs to be established. Output volume is a key factor in the
overhead absorption rate.
(iv)
A suitable basis for overhead absorption must be selected, especially where a business
produces more than one product.
However, it is a quick, simple and cheap method of pricing which can be delegated to junior
managers (which is particularly important with jobbing work where many prices must be decided
and quoted each day) and, since the size of the profit margin can be varied, a decision based on a
price in excess of full cost should ensure that a company working at normal capacity will cover all
of its fixed costs and make a profit.
The advantages and disadvantages of a marginal cost-plus approach to pricing
Here are the advantages.
(i)
(ii)
The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect
demand conditions.
(iii)
It draws management attention to contribution, and the effects of higher or lower sales
volumes on profit. In this way, it helps to create a better awareness of the concepts and
implications of marginal costing and cost-volume-profit analysis. For example, if a product
costs $10 per unit and a mark-up of 150% is added to reach a price of $25 per unit,
management should be clearly aware that every additional $1 of sales revenue would add
60 pence to contribution and profit.
There are, of course, drawbacks to marginal cost-plus pricing.
(b)
(i)
Although the size of the mark-up can be varied in accordance with demand conditions, it
does not ensure that sufficient attention is paid to demand conditions, competitors' prices
and profit maximisation.
(ii)
It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently
high to ensure that a profit is made after covering fixed costs.
Calculate the full cost per unit of each product using absorption costing
The full cost of each product will include indirect costs allocated to each product using a
predetermined overhead absorption rate. In the case of KL, this is based on direct labour hours.
Variable cost/unit
Direct materials
Direct labour
Production overhead (W)
Full cost/unit
W
$
X
$
Y
$
35.00
40.00
18.00
93.00
45.00
30.00
13.50
88.50
30.00
50.00
22.50
102.50
347
Working
Total
4
15,000
60,000
3
24,000
72,000
5
20,000
100,000
232,000
4
18.00
3
13.50
5
22.50
Calculate the full cost per unit of each product using ABC
We have listed the steps taken to calculate the unit costs using an ABC system of costing. The
references to workings are to the workings below.
Step 1
Step 2
Batches
Batch size (units)
Annual units
Annual number of batches
Total
500
15,000
30
400
24,000
60
1,000
20,000
20
Supplier orders
Per batch
Annual number of batches
4
30
3
60
5
20
120
180
100
400
Machine hours
Per unit
Annual units
Annual machine hours
5
15,000
75,000
8
24,000
192,000
7
20,000
140,000
407,000
110
Use this information to calculate the activity cost driver rates in working below. You
should also be able to use information provided in the table in the question.
Working
Cost driver rates
348
Step 3
Apply these cost driver rates to the supplier orders, batch sizes and machine hours
for each product. This will give you the unit cost for each product for each cost pool.
See workings 1, 2,3 and 4.
Workings
W
4
500
= 4/500
550
4.40
X
3
400
= 3/400
550
4.125
Y
5
1,000
= 5/1,000
550
2.75
W
500
909
1.82
X
400
909
2.27
Y
1,000
909
0.91
W
5
X
8
Y
7
0.98
4.90
0.98
7.84
0.98
6.86
W
5
0.80
4.00
X
8
0.80
6.40
Step 4
Y
7
0.80
5.60
You should now be able to calculate the full unit cost using the information you have
already calculated slotted into a table as below.
Using activity based costing, unit costs for the three products would be as follows.
W
$/unit
35.00
40.00
4.40
1.82
4.90
4.00
90.12
Direct material
Direct labour
Material ordering costs (W1)
Machine set-up costs (W2)
Machine running costs (W3)
General facility costs (W4)
349
X
$/unit
45.00
30.00
4.13
2.27
7.84
6.40
95.64
Y
$/unit
30.00
50.00
2.75
0.91
6.86
5.60
96.12
Alternative solution
The alternative way to approach this problem, given that we have information on all the products
that the costs have to be shared between, is to use ratios rather than cost drivers.
Step 1
Step 2
Work out the annual activity for each cost driver (same calculation as in Step 1 above).
120
x 220,000
400
= 66,000
30
x 100,000
Step 3
60
20
110
= 54,545
x 100,000
110
= 18,182
75
x 400,000
407
192
140
75
x 324,000
x 100,000
x 220,000
400
= 55,000
x 400,000
407
= 188,698
x 400,000
407
= 137,592
192
140
x 324,000
407
= 59,705
407
= 152,845
x 324,000
407
= 111,450
$226,688
$495,088
$322,224
Calculate indirect cost per unit and full cost per unit
W
226,688
495,088
322,224
Budgeted annual
production (units)
15,000
24,000
20,000
$15.12
$20.64
$16.12
35.00
40.00
45.00
30.00
30.00
50.00
$90.12
$95.64
$96.12
(d)
x 220,000
400
= 99,000
100
110
= 27,273
= 73,710
General facility costs
180
350
X
$
88.50
95.64
(7.14)
Y
$
102.50
96.12
6.38
Costing
ABC helps with cost reduction because it provides an insight into causal activities and
allows organisations to consider the possibility of outsourcing particular activities, or even of
moving to different areas in the industry value chain, eg reduce numbers of orders and
increase size of batches.
Many costs are driven by customers (delivery costs, discounts, after-sales service and so
on), but traditional cost accounting does not account for this. Companies may be trading
with certain customers at a loss but may not realise it because costs are not analysed in a
way that would reveal the true situation. ABC can be used in conjunction with customer
profitability analysis (CPA) to determine more accurately the profit earned by serving
particular customers.
Pricing
ABC establishes a long-run product cost and because it provides data which can be used to
evaluate different business possibilities and opportunities it is particularly suited for
decisions such as pricing. Pricing has long-term strategic implications and average cost is
probably more important than marginal cost in many circumstances. An ABC cost is an
average cost, but it is not always a true cost because some costs such as depreciation are
usually arbitrarily allocated to products. An ABC cost is therefore not a relevant cost for all
decisions.
Profit
The differences in unit costs between full cost, and ABC cost shown in the table show that
management need to consider a few actions from the results of ABC costing. Should they
increase the price of X which has a higher ABC cost than full cost?
On the other hand should management reduce the price of Y which has a lower ABC cost
than full cost?
Managing Director
From:
Date:
May 20X9
Subject:
This report gives a brief overview of the principles of Total Quality Management (TQM), the costs involved
and the relationship between compliance and non-compliance costs (also known as conformance and nonconformance costs).
Principles of TQM
The key principle of TQM is get it right first time the belief that the costs of preventing mistakes in the
first place are less than the costs of correcting these mistakes once they occur.
Another basic principle is dissatisfaction with the status quo the belief that it is always possible to
improve (get it right next time). This is known as continuous improvement.
In order for TQM to work properly, everyone within the organisation must be committed to its principles
and the ultimate objective of producing good quality goods or services. In order to encourage this
commitment, everyone should be encouraged to make suggestions that might improve quality and given
responsibility for achieving quality results.
351
Quality costs
There are four categories of costs that are related to TQM.
(a)
Prevention costs
Prevention costs are incurred prior to or during production in order to prevent sub-standard or
defective goods being produced. Examples include quality engineering and training staff in aspects
of quality control.
(b)
Appraisal costs
These costs are incurred once the goods or services have been produced to ensure that outputs
meet quality standards. Examples include inspection costs and acceptance testing.
(c)
(d)
10 M plc
(a)
Assembly labour hours
Variable costs
Assembly labour (W1, W2, W3)
Furniture packs (W4)
Other materials (W5)
Variable overheads (W6)
Fixed costs
Manager
Stepped-fixed cost (W6)
Total departmental fixed costs
Central costs
Original
budgeted
1
6,400
$
Flexed
budgeted
2
7,140
$
Actual
costs
3
7,140
$
Variance
(3 2)
49,920
224,000
23,040
34,560
331,520
55,692
249,900
25,704
38,556
369,852
56,177
205,000
24,100
76,340
361,617
485 (A)
44,900 (F)
1,604 (F)
37,784 (A)
8,235
2,050
18,500
20,550
9,000
361,070
2,050
27,000
29,050
9,000
407,902
2,050
27,000
29,050
9,000
399,667
8,235 (F)
352
Workings
Both budgeted and actual assembly labour costs given include manager's fixed salary of
$2,050 which has to be deducted
$51,970 $2,050 = $49,920
Budgeted assembly labour costs are flexed to reflect actual labour hours by multiplying the
cost by
actual hours
budgeted hours
$49,920
3
7,140 hrs
= $55,692
6,400 hrs
We need to deduct the assembly manager's fixed salary of $2,050 from the actual costs of
$58,227
$58,227 $2,050 = $56,177
We need to flex the original budget for the cost of furniture packs to reflect the actual labour
hours worked.
$224,000
We need to flex the original budget for other materials to reflect the actual labour hours
worked
$23,040
7,140 hrs
= $249,900
6,400 hrs
7,140 hrs
= $25,704
6,400 hrs
The budgeted overheads include a fixed cost of $9,000 and a stepped-fixed cost which we
need to work out using the high-low method. The stepped fixed cost changes when the
assembly hours exceed 7,000 hours. In order to identify these stepped fixed costs we
compare the overhead costs for the two different levels of labour hours at 7,500 and
10,000 hours respectively.
At 7,500 assembly labour hours we have
a + 7,500 b = $76,500
At 10,000 assembly labour hours we have
a + 10,000 b = $90,000
Where, a is defined below as:
a = Stepped fixed cost + $9,000
a + 10,000 b = $90,000 (1)
a + 7,500 b = $76,500 (2)
Subtracting (2) from (1) we get
2,500 b = $13,500
b=
$13, 500
= 5.4
2, 500
353
To find the stepped fixed cost component at 5,000 hours, we substitute the value of b =
5.4 in the following equation
a1 + 5,000 b = $54,500
where a1 is the stepped fixed cost at 5,000 units (including the central fixed cost of $9,000)
a1 + 5,000 5.4 = $54,500
a1 = $27,500
Deducting the central fixed cost of $9,000, the stepped fixed cost for 5,000 units is
$27,500 less $9,000 = $18,500.
(b)
The revised format of the statement is more helpful as it has been flexed to the actual level
of activity and therefore compares like with like.
The revised format separates costs into variable (and hence controllable) costs and fixed
costs or central costs (and therefore uncontrollable). This will facilitate analysis,
performance measurement and responsibility accounting.
The format originally submitted has some inconsistencies which make comparison very
difficult. In addition to the fact that the format was not comparing like with like, the
manager's fixed salary was included in overheads when labour assembly hours related only
to the variable labour input.
(c)
Top tips. Whereas bullet points provide a clear way of presentation, the examiner stressed that
these should be supplemented by adequate explanatory narrative. Make sure you relate the
discussion to the specific entity in question.
They are based on information from employees most familiar with the department
Knowledge spread among several levels of management is pulled together
Morale and motivation is improved
They increase operational managers' commitment to organisational objectives
In general they are more realistic
Co-ordination between units is improved
Specific resource requirements are included
Senior managers' overview is mixed with operational level details
Individual managers' aspiration levels are more likely to be taken into account
The allocation of overheads in M plc is likely to vary considerably depending on the size, complexity
and value of the furniture being assembled. It is, therefore, important to involve employees with
detailed knowledge of the process. This will not only draw on useful experience but also increase
motivation and commitment.
Disadvantages of M plc moving to a system of participative budgeting
In considering the advantages of introducing participative budgeting M plc needs to be aware of the
potential disadvantages. The most important potential problem, apart from participative budgets
requiring more resource and taking longer to prepare, is the possible introduction of slack.
Negotiated style of budgeting
A negotiated budget is a 'budget in which budget allowances are set largely on the basis of
negotiations between budget holders and those to whom they report.'
354
At the two extremes, budgets can be dictated from above or simply emerge from below but, in
practice, different levels of management often agree budgets by a process of negotiation. In the
imposed budget approach, operational managers will try to negotiate with senior managers the
budget targets which they consider to be unreasonable or unrealistic. Likewise senior management
usually review and revise budgets presented to them under a participative approach through a
process of negotiation with lower level managers. Final budgets are therefore most likely to lie
between what top management would really like and what junior managers believe is feasible. The
budgeting process is hence a bargaining process and it is this bargaining which is of vital
importance, determining whether the budget is an effective management tool or simply a clerical
device.
(d)
Long-term planning
This involves selecting appropriate strategies so as to prepare a long-term plan to attain the
organisation's objectives.
This long-term corporate plan serves as the long-term framework for the organisation as a
whole but for operational purposes it is necessary to convert the corporate plan into a series
of short-term plans (or budgets), usually covering one year, which relate to sections,
functions or departments.
(2)
Short-term planning
The annual process of short-term planning (or budgeting) should be seen as steps in the
progressive fulfilment of the corporate plan as each short-term plan steers the organisation
towards its long-term objectives.
The short-term budgets for the various functions of the organisation are coordinated and
consolidated by the budget committee into the master budget, which is a summary of
organisation-wide plans for the coming period. The master budget is what is known as a
fixed budget. This does not mean that the budget is kept unchanged. Revisions will be
made to it if the situation so demands. It simply means that the budget is prepared on the
basis of an estimated volume of production and sales, but no plans are made for the event
that actual volumes differ from budgeted volumes.
355
11
Mills Ltd
(a)
Production manager
The production manager instigated the new higher quality production approach and this has
fundamentally changed the nature of the business. Before the new system started, there were
favourable material variances for price and yield and the production manager would have received
a bonus as a result.
The higher quality ingredients are more expensive and this results in adverse material price and
mix variances in March. The material yield variance is favourable but not by enough to compensate
for the adverse variances. This means that the production manager would not receive a bonus
under the current scheme.
Sales of the units have improved significantly so customers presumably appreciate the improved
quality and mix of materials. The production manager does not receive any credit for the favourable
sales variances and that does not seem fair.
Sales manager
In contrast, the sales variances that the sales manager is responsible for have moved from adverse
in February to favourable in March. The new approach has therefore been a success with
customers. The sales manager will have had to sell the improved units to customers and is
therefore partly responsible for the improvement, but the original impetus came from the
production manager.
Bonus scheme
The bonus scheme does not seem to be fair as it will not reward the two managers fairly for their
efforts. They are both responsible for the improved sales but it is very difficult to fairly allocate
responsibility in this situation. Some form of sharing of responsibility and reward is required.
The standards that the variances are based on need to be changed to reflect the new approach that
the business is taking. For example, the standard price of the materials needs to be increased.
(b)
Variance calculations
Material price variances
$
684
741
57 (A)
$
4,620
5,610
990 (A)
$
11,220
11,880
660 (A)
$
2,289
2,747
458 (A)
$
2,165 (A)
356
A1
B2
C3
D4
Actual
quantity
Standard mix
Kg
5869.5
5869.5
5869.5
5869.5
23,478
Variance
Kg
169.5
730.5
730.5
1,291.5
Standard
cost
per kg
$
0.12
0.70
1.70
0.50
Variance
$
20.34 (F)
511.35 (A)
1,241.85 (A)
645.75 (F)
1,087.11 (A)
A1
B2
C3
D4
0.1
0.1
0.1
0.1
kg
kg
kg
kg
$0.12
$0.70
$1.70
$0.50
$
0.012
0.070
0.170
0.050
0.302
Units
58,695
60,000
1,305 (F)
$394.11 (F)
Alternative method
A1
B2
C3
D4
Standard
quantity
Standard mix
Kg
6,000
6,000
6,000
6,000
24,000
Actual quantity
Standard mix
Kg
5869.5
5869.5
5869.5
5869.5
23,478
60,000
50,000
10,000
$0.35
$3,500 (F)
357
Standard cost
Variance
Kg
130.5
130.5
130.5
130.5
per kg
$
0.12
0.70
1.70
0.50
Variance
$
15.66
91.35
221.85
65.25
394.11 (A)
12
Silk Imports
(a)
Financial performance
Sales growth
Silk Imports appear to have made an excellent start with initial sales of $420,000 growing by 62%
((680,000 420,000)/420,000 100%) to Quarter 2. This is particularly impressive given the
acknowledged competitiveness of this business sector.
Gross profit
The gross profit margin in Quarter 1 was 52% (218,400/420,000 100%) and 50%
(339,320/680,000 100%) in Quarter 2. The level of margin may be as expected for this
business sector but we would need industry average data for comparison.
However, a fall in margin needs to be investigated. It could be that Silk Imports were initially able
to source cheaper scarves but the rapid growth meant that alternative, more expensive suppliers
had to be found. Alternatively, competitors quickly responded to this new entrant and lowered their
prices in response. This pressure could have forced Silk Imports to lower their prices.
Website Development
All website development costs are being written off as incurred so we would expect costs to be
higher in the initial quarters. The website costs are over a third of total expenses, so the initial loss
is mostly explained by this write-off and does not therefore give any major cause for concern.
Administration costs
Although administration costs have risen in absolute terms, as a percentage of sales they have
fallen from 23.9% (100,500/420,000 100%) to 22.2% (150,640/680,000 100%).
Administration costs are the second biggest expense so very important to control.
This could indicate that administration costs are being effectively controlled which is good news. It
could also be because fixed overheads are being spread over a larger volume and this will continue
to improve as the business grows.
Distribution costs
These costs form the smallest proportion of total expenses (about 6%) and the proportion of
distribution costs to sales has remained constant at 4.9% (20,763/420,000 100%). These
costs will be subject to external influences such as a general rise in postage costs.
Launch marketing
This is similar to the website costs as it is expected to fall once the business is established. Silk
Imports will need to continue to market their website but this is likely to be cheaper than the initial
big launch marketing campaign. The negative impact on profitability will therefore reduce over
time.
Other variable expenses
These have again increased in line with the sales volume and are 11.9% of sales
(50,000/420,000 100%).
(b)
358
On time delivery
This has dropped significantly from 95% to 89% and this is worrying. The service provided to
customers is a key differentiator, especially if the company is competing on quality not price.
Customers will go elsewhere if their expectations are not met. Action will need to be taken to
remedy this problem.
Sales returns
This is again a key indicator of quality and whether customers' expectations are being met. Returns
have risen from 12% to 18% and are now above the industry average of 13%. Returns are to be
expected on Internet sales where the product may look different in reality, but a higher than
average rate means that the internet is not adequately describing and illustrating the products.
Again, quality may be less than customers expect.
Alternatively, the pressure to dispatch orders may be resulting in errors or packaging problems.
Either of these reasons does not bode well for the business and action must be taken to remedy the
problem.
System downtime
Customers who use shopping websites are usually time pressured individuals who will not react
well to delays in loading pages. It is all too easy to immediately switch to a competitor's website so
it is essential that system downtime is kept to an absolute minimum to avoid lost sales.
It would be useful to compare the figures with an industry average but the important point is that
system downtime has doubled. This could be due to pressure on the website as a result of the
volume of demand. As the website development has been such a costly and important part of the
business set-up, the owners of Silk Imports should have an urgent discussion with the website
developers to come up with a solution.
Conclusion
Silk Imports are doing well in terms of sales growth and potential profitability for a brand new
business. However the owners need to focus their attention on the accuracy of order delivery,
website reliability and the quality of the product. Further investigation needs to be made of the fall
in gross profit margin.
13 Y and Z
(a)
The following conditions are necessary for the successful introduction of such centres.
The centres must have a measurable output. This does not mean that the output must
necessarily be sold on the external market. It may be transferred internally for use in another
part of the organisation. In this case the 'revenue' generated is determined by the use of a
transfer price.
It must be possible for the centre manager to exercise control over the level of output.
For an investment centre, it must be possible for the centre manager to exercise control
over the level of investment in the centre, and for the level of investment to be measured
objectively.
A reporting system must be established which provides rapid and accurate feedback to keep
centre managers informed about their performance.
Centre managers must accept the change and must be willing to accept the extra
responsibility associated with their new role. Provision must be made for adequate
education and training in the operation of the new responsibility accounting system.
Central management must also fully understand and accept the new system, particularly if
they are required to delegate authority for decisions which they are accustomed to making
themselves.
359
(b)
Top tips. The question gives the operating statement for one month and requires the calculation of
the annualised ROI. This should not throw you, all you need to do is multiply the net income before
tax by 12.
This is actually a fairly straightforward question providing plenty of scope for meaningful and
relevant discussion.
Where you are asked to comment on performance (as you often are in this paper) be prepared to
pose questions and identify further information that may be required.
Although you are asked to calculate the ROI, your discussion may supplemented with the
secondary performance ratios of profit margin and asset turnover.
(i)
Y
122,000 12 =
1,464,000
Z
21,000 12 = 252,000
ROI
1,464,000
= 15%
9,760,000
252,000
= 20%
1,260,000
The two divisions Y and Z operate in similar markets. Of the two, Z is the smaller one in
terms of both sales and divisional net assets. Z also has the higher ROI of the two, being
20% compared to Y's 15%.
However, what is surprising is the different proportion of variable costs in relation to sales
for the two divisions. Variable costs constitute 38 percent of sales for Y and 56 percent of
sales for Z. We need further information to explain the higher variable costs of Z. Could
these be related to the lower divisional assets? There is a range of possible explanations here
and further investigation will be necessary.
It is possible that division Z's assets are old and lead to inefficiency in production. Although
Z's overall ROI is higher, this may be because its assets are old and do not reflect the
current replacement cost. The results highlight the fundamental problem with using ROI as a
single measurement of performance. ROI can lead to sub-optimal decisions where a
manager is unwilling to undertake further investment which, although giving a positive
return, may reduce the current ROI. This may be the case with division Z.
There is no indication that division Z is outsourcing part of its production process, which
may have been a possible explanation for higher variable costs and lower divisional assets.
Further investigation is required.
Looking at the secondary performance ratios of profit margin and asset turnover below, it is
easy to see that division Y has the higher profit margin and lower asset turnover.
Secondary performance ratios
For division Y
Divisional profit
ROI =
Divisional sales
ROI =
=
For division Z
ROI =
360
Profit margins
122,00012
900,00012
Asset turnover
900,00012
13.56%
21,00012
555,00012
1.1%
= 15%
555,00012
3.78%
Divisional sales
9,760,000
1,260,000
5.286%
= 20%
We need to look at the relative ages of the assets and their relationship to replacement cost
to be able to assess further the divisional performance. We also need further information on
the basis for apportioning central costs. If only controllable income is assessed as a
proportion of divisional net assets, the returns are even more strikingly different (56.56% for
Y and 191% for Z).
(ii)
RI =
For Z
RI =
The absolute score RI is positive for both divisions. This means that sufficient residual
income is left for the shareholders after an imputed interest charge on divisional assets is
deducted from net profit. Whereas the relative measure ROI is higher for division Z, the
absolute measure RI is higher for division Y.
RI is a superior measure technically but no single measure alone is sufficient for a
meaningful performance evaluation. As the cost of capital rises, RI will fall. The imputed
interest charge should be calculated on the replacement cost of assets. It would appear that
here we have assets at historic cost.
(iii)
ROI
Advantages
ROI is a relative measure expressed in percentage terms. As such it is easy to understand
and can be readily compared against a required benchmark rate.
Disadvantages
ROI can lead to sub-optimal decisions. As the case of divisions Y and Z illustrates, it is not
certain whether it is better to have a return of 20% on a 1.2 million investment or a 15%
on a 9.8 million investment.
Shareholders may prefer the former in that less of their funds are tied in the business.
However, the use of ROI may tend to limit growth as a manager assessed on ROI alone will
be unwilling to undertake further investment providing a return lower than the current one
he is earning.
Residual Income
Advantages
Residual income (RI) requires that a capital charge is imputed on each division's profit.
RI does not suffer from the potential problems of ROI as any investment providing a return
in excess of the required rate is likely to be accepted.
Disadvantages
The imputed capital charge is based on assets at historic cost. Divisions with older assets
may appear to be doing better in the short term.
Other methods
Other methods of performance assessment are Economic Value Added (EVA) and
profitability measures such as net profit margin and gross profit margin.
EVA is similar to RI in that it is an absolute measure. However, EVA is considered an
improved variant of RI in that it is based on economic and not accounting profit. Moreover,
the capital charge is based on the replacement cost of assets.
Net profit margin is measured as a percentage of net profit to turnover. Gross profit is
measured as a percentage of gross profit to turnover.
361
14 FP Photocopiers
(a)
Per repair
54
45
30
129
66
195
78
273
Parts
Labour (3 hrs 15 per hour)
Variable overheads ( 3 hrs 10 per labour hour)
Marginal cost
Fixed overheads (3 hrs 22 per labour hour)
Total cost
Mark-up (40% of total cost)
Selling price
64,500
33,000
97,500
39,000
136,500
Sales
Costs
Profits
Sales
department
120,000
((136,500)
(16,500)
Service
department
136,500
(97,500)
39,000
FP
120,000
(97,500)
22,500
Sales
department
120,000
64,500
55,500
Service
department
64,500
97,500
(33,000)
FP
120,000
97,500
22,500
Sales
department
120,000
90,000
Service
department
33,000
(33,000)
FP
120,000
(90,000)
33,000
(3,000)
Sales
Costs
Profits
Repairs carried out by RS
Sales
Repair costs (180 per repair 500)
Fixed overheads
Profit/(loss)
(b)
(i)
(ii)
30,000
It may lead to implied poor performance by the Sales Department. The performance
measures and reward system would lead to sub-optimal decisions by the manager of
the Sales Department.
Why is the quote by RS lower than the cost of the Services Department?
Are fixed costs committed?
What is the standard quality of the repairs by RS?
362
(c)
Is the offer by RS a short-term offer? Is the price likely to remain stable or rise in the
long term?
Why are the costs of the Service Department higher than the price charged by RS?
Can the Services Department find other work to take up the capacity released if RS do
the guaranteed repairs?
By structuring the departments as profit centres the organisation benefits from the local
knowledge of decentralised units and improved, faster decision making.
Profit centres are also likely to increase motivation of local managers and by reducing
bureaucracy, lead to high efficiency.
The increased autonomy of local managers provides good training ground for the company.
Disadvantages
(d)
REPORT
To:
From:
Date:
Subject:
Introduction
This report outlines an appropriate transfer pricing policy for transfers between SW Limited
and AL Limited.
The transfer price might therefore be set at slightly less than variable cost so that the two
divisions can share the cost savings from internal transfers compared with external sales.
363
Note that standard variable cost should be used because actual costs vary with volume,
seasonal and other factors and because, if used as a basis for transfer prices, any
inefficiency in SW Limited could be passed on to AL Limited in the form of an increased
transfer price.
Given that SW Limited earns no contribution on transfers at variable cost, it will be
indifferent between making the transfers and producing no output. Head office intervention
may therefore be required to ensure that transfers take place.
4
I hope this information has proved useful. If you wish to discuss the points raised please do
not hesitate to contact me.
15
PCs R Us
(a)
Division P is only making components that are transferred to division C. The transfer price is
currently set at full cost plus. Division P is recovering all the costs that it incurs and making a
guaranteed mark up on every transaction.
Division P is therefore likely to be very happy with this transfer price. As the price is at full cost not
standard full cost, there is no incentive at all for P division to control its costs. Whatever it spends,
division C will effectively pay for and it will still make a guaranteed mark up.
Division C will pay whatever the components cost to make. As this is on an actual basis, that cost
can vary and it will make it very hard for division C to plan their expenditure.
Additionally, division C will effectively be penalised if division P overspends. Any increase in the
costs of the components will directly reduce division Cs profit. As profit is the performance
measure used, division C will be very unhappy with this transfer price. They may even consider
going externally to source the components as they will be able to negotiate a more competitive price
that the current full cost plus that they are being charged. This cost will be agreed upon up front
and will not change.
This transfer price is clearly not in the best interest of PCs R US. It is encouraging inefficient
spending and does not encourage cost control. This may even lead to components being bought in
from external suppliers which may reduce PCs R US overall level of profit.
(b)
Division P is essentially a cost centre, yet it is being assessed on the basis of profit and is not
measured on its ability to control its costs.
A better transfer price would be to use standard cost plus. In this way both divisions could still be
measured consistently ie by both using profit.
364
Division Ps profitability would therefore be determined by how well it has controlled its costs. If it
spends more than the standard it will reduce its profitability. This will result in a lower cost basis
for the company.
Division C would be much happier with a transfer price of standard cost plus as it knows in
advance exactly what it will pay. Additionally, it is only paying the agreed amount, The only items
which can therefore affect the rate of its profitability are items that are internal to its division, i.e.
how well it controls its own costs and the selling prices that it agrees with the customers.
365
366
Appendix A
Maths tables and formulae
367
368
Tables
Area under the normal curve
This table gives the area under the normal curve between the mean and the point Z standard deviations above
the mean. The corresponding area for deviations below the mean can be found by symmetry.
Z=
(x )
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.0
0.1
0.2
0.3
0.4
.0000
.0398
.0793
.1179
.1554
.0040
.0438
.0832
.1217
.1591
.0080
.0478
.0871
.1255
.1628
.0120
.0517
.0910
.1293
.1664
.0160
.0557
.0948
.1331
.1700
.0199
.0596
.0987
.1368
.1736
.0239
.0636
.1026
.1406
.1772
.0279
.0675
.1064
.1443
.1808
.0319
.0714
.1103
.1480
.1844
.0359
.0753
.1141
.1517
.1879
0.5
0.6
0.7
0.8
0.9
1.0
.1915
.2257
.2580
.2881
.3159
.3413
.1950
.2291
.2611
.2910
.3186
.3438
.1985
.2324
.2642
.2939
.3212
.3461
.2019
.2357
.2673
.2967
.3238
.3485
.2054
.2389
.2704
.2995
.3264
.3508
.2088
.2422
.2734
.3023
.3289
.3531
.2123
.2454
.2764
.3051
.3315
.3554
.2157
.2486
.2794
.3078
.3340
.3577
.2190
.2517
.2823
.3106
.3365
.3599
.2224
.2549
.2852
.3133
.3389
.3621
1.1
1.2
1.3
1.4
.3643
.3849
.4032
.4192
.3665
.3869
.4049
.4207
.3686
.3888
.4066
.4222
.3708
.3907
.4082
.4236
.3729
.3925
.4099
.4251
.3749
.3944
.4115
.4265
.3770
.3962
.4131
.4279
.3790
.3980
.4147
.4292
.3810
.3997
.4162
.4306
.3830
.4015
.4177
.4319
1.5
1.6
1.7
1.8
1.9
.4332
.4452
.4554
.4641
.4713
.4345
.4463
.4564
.4649
.4719
.4357
.4474
.4573
.4656
.4726
.4370
.4484
.4582
.4664
.4732
.4382
.4495
.4591
.4671
.4738
.4394
.4505
.4599
.4678
.4744
.4406
.4515
.4608
.4686
.4750
.4418
.4525
.4616
.4693
.4756
.4429
.4535
.4625
.4699
.4761
.4441
.4545
.4633
.4706
.4767
2.0
2.1
2.2
2.3
2.4
.4772
.4821
.4861
.4893
.4918
.4778
.4826
.4864
.4896
.4920
.4783
.4830
.4868
.4898
.4922
.4788
.4834
.4871
.4901
.4925
.4793
.4838
.4875
.4904
.4927
.4798
.4842
.4878
.4906
.4929
.4803
.4846
.4881
.4909
.4931
.4808
.4850
.4884
.4911
.4932
.4812
.4854
.4887
.4913
.4934
.4817
.4857
.4890
.4916
.4936
2.5
2.6
2.7
2.8
2.9
.4938
.4953
.4965
.4974
.4981
.4940
.4955
.4966
.4975
.4982
.4941
.4956
.4967
.4976
.4982
.4943
.4957
.4968
.4977
.4983
.4945
.4959
.4969
.4977
.4984
.4946
.4960
.4970
.4978
.4984
.4948
.4961
.4971
.4979
.4985
.4949
.4962
.4972
.4979
.4985
.4951
.4963
.4973
.4980
.4986
.4952
.4964
.4974
.4981
.4986
3.0
3.1
3.2
3.3
3.4
3.5
.49865
.49903
.49931
.49952
.49966
.49977
.4987
.4991
.4993
.4995
.4997
.4987
.4991
.4994
.4995
.4997
.4988
.4991
.4994
.4996
.4997
.4988
.4992
.4994
.4996
.4997
.4989
.4992
.4994
.4996
.4997
.4989
.4992
.4994
.4996
.4997
.4989
.4992
.4995
.4996
.4997
.4990
.4993
.4995
.4996
.4997
.4990
.4993
.4995
.4997
.4998
369
END OF APPENDIX A
370
Appendix B
Formulae to learn
371
372
Formulae to learn
Cost accounting concepts and techniques:
Overhead Absorption rate
Budgeted overhead
OAR =
Budgeted activity
Fixed costs
Unit contribution
Breakeven revenue =
Fixed costs
or Breakeven point x SP
C/S ratio
Breakeven point =
Fixed costs
Weighted average unit contribution
Breakeven revenue =
Fixed costs
Weighted average C/S ratio
Pricing decisions:
PED =
%x
%P
% change in x
% change in P
Demand function = P = a - bx
selling price
change in price
change in quantity
373
Cost planning:
Target Cost = Selling price desired profit margin
Cost gap = Target cost estimated cost
Cost analysis:
Cost pool ($)
OAR
Cost driver
Cost / hour
TPAR
Performance evaluation:
Profitability ratios
ROCE
Asset turnover
PBIT
Capital employed
Net profit
Sales
100 %
Gross profit
Sales
100 %
100 %
Sales
Capital employed
Quick ratio
Receivables period
Current assets
Current liabilities
Current assets - inventories
Current liabilities
Average receivables
Credit sales
374
365
Inventory periods:
Finished Goods
WIP
Raw Material
Payables period
Average payables
Credit purchases
365
365
365
ROI
Residual income =
EVA
Divisional Profit
Divisional Investment
100
Divisional profit
(X)
Residual Income
(X)
X
375
END OF APPENDIX B
376
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